One of the keys to happiness in life is marrying the right person. We guard ourselves against marrying the wrong person and we certainly avoid marrying people at random.
Likewise, a key to successful business is working with the right partners. Much like the perfect union, business partners often rely on each other for the success of their business and their economic prosperity. Business owners are careful to avoid going into business with the wrong person and they do not pick random partners.
Business ownership is more fluid than marriage. Partners may come and go from a business by buying and selling equity in the venture. Often, these moves are constrained by carefully negotiated partnership agreements, and new partners only enter the business with approval of existing partners. Sometimes, however, the law will dictate that a partner must transfer his or her equity to an unrelated party, allowing new partners into a business without approval of the other partners.
For instance, one partner may lose his equity in a business following a legal event, like bankruptcy or divorce. In such a case, the other partners may now find themselves in business with their old partner’s creditors or ex-spouse. Or, when a partner dies, the other partners may now be in business with their late partner’s heirs, such as a widow, children, or charities. Obviously, taking on new partners this way is less than ideal.
Most states have laws protecting a business when a partner loses control of his equity through a legal proceeding or at death. New equity holders generally cannot control the business, but they do have substantial rights and powers that may be disruptive to the business. Fortunately, business owners have a powerful mechanism that can protect them against becoming partners with random strangers through compelled transfer or death as a result of the “buy-sell agreement”.
A buy-sell agreement is a legally enforceable contract that generally says when a partner would otherwise transfer his or her equity in a business to a third party, then the remaining partners are allowed to intervene and buy that partner’s interest instead. This compelled sale will allow the selling partner to exit, but will maintain ownership amongst the remaining partners, and not allow a random outsider in as a new partner.
Partners thinking about a buy-sell agreement should take several factors into account. First, they need to consider what kind of events will trigger the agreement. Common triggers include the death of a partner or any state-compelled transfer of a partner’s equity, such as bankruptcy or divorce. The agreements can also be broader by allowing partners to interrupt a partner’s voluntary sale to a third party and require that partner to sell back to the other partners instead (generally called a “right of first refusal”) or by allowing partners to buy out a partner at a specific future date, for example, after trial period for that partner.
Second, partners should give thought to where the funds will come from if a buy-sell is triggered. It is likely that most business people are not sitting on a pile of cash, ready to buy their partners out. As such, buy-sell agreements often give buying partners time to secure financing to make the purchase or may require the selling partner to accept a promissory note as payment for his or her shares. One simple source of funds is for partners to maintain life insurance policies on each other and use the death benefits to buyout a partner’s interest in the event of death.
Third, partners should consider how to measure the price to be paid when buying out one of their own. This can be a tough one because most closely-held businesses are not valued regularly. A buy-sell may require the parties to engage in a valuation process prior to sale or it may simply state a flat price that the partners will revise from time to time. In the case of death, a buy-sell may simply state that the equity will be bought for a value equaling life insurance proceeds.
There are other ancillary considerations for buy-sell agreements. Will the agreement apply equally to all partners or is the majority partner exempt? If the agreement is triggered, is the purchase mandatory or merely optional for the remaining partners? Should the agreement be between individual partners or between the company and the partners (often known as a “redemption agreement”)?
Whatever specific terms a buy-sell may contain, business owners may find such an agreement a useful tool to maintain ownership and control of their businesses.