by: Thomas Fafinski
…or Worse, their Ex-Spouse!
Business Succession Planning and Buy-Sell Agreements.
Without proper planning, you could have your partner’s ex-spouse or creditor as a new partner. An interest in a business is an asset that can be levied upon by creditors, even ex-spouses. Additionally, you could find that your biggest source of competition is your partner’s new business. Or, if your partner dies, his or her estate could be selling the interest in your business to outside investors. Without proper planning, you could be stuck with a partner that doesn’t work in the business, is competing against you, or is a group of investors, yet derives value from your continued sweat and hard work.
Buy-sell agreements address the ability of business owners to purchase the interest of another business owner at these critical moments. Normally, these restrictive agreements are used as a method of avoiding litigation. Creating predictable outcomes before a dispute arises is almost always easier than resolving the dispute when after it happens. Buy-sell agreements also provide for ownership continuity and can minimize the effects of certain significant events, referred to as triggering events, on the operation of the going concern.
You might be interested in restricting the ownership of the company to the current members or a defined group of prospective owners. You might want to create a market for the sale of your ownership interest. It may be as simple as creating a method of protecting the interests of a minority [less than 50%] owner from being treated differently in sale transactions. Most often, though, these agreements provide continuity of ownership, thereby avoiding becoming partners with your former partner’s ex-spouse, creditor or bankruptcy trustee.
A triggering event is normally significant enough that the event itself will make it difficult to continue current operations without disruption of the business. Typical triggering events include:
- an owner attempting to sell their interest [letting an outsider into the business and disrupting management],
- death of an owner,
- an owner engaging in competition,
- an owner becoming financially insolvent [risking creditor involvement in the business],
- an owner getting divorced [and the risks of the ex-spouse becoming an owner],
- an owner being terminated from employment by the business,
- retirement by someone with ownership interest or lack of involvement, and
- even disability of an owner.
How the owners foresee the business continuing must be analyzed when drafting a buy-sell agreement. Part of the analysis includes whether the options created by the buy-sell agreement after a triggering event are put options, call options or a combination. For instance, you might want the company to be obligated to purchase a deceased owner’s interest by utilizing the proceeds from a life insurance policy. This is a “put” option. You may want to be able to purchase the owner’s interest in the event of retirement or engaging in competition, without being obligated to purchase the interest. This is a “call” option.
Another critical aspect to the analysis is a determination of value. Will the company be appraised annually, will it have a formula for determining a price [i.e. a function of earnings, a weighted capitalized earnings formula, book value multiple], will the price be agreed to annually or will we have an appraisal process that triggers upon the occurrence of a triggering event?
Why doesn’t every business owner have a buy-sell agreement? Buy-sell Agreements are normally quite lengthy and difficult for non-lawyers to review and understand. A lot is happening in these agreements and there generally is not a pressing issue at the time they are being considered. The legal industry has done a poor job of making these agreements easy to understand. Typical buy-sell agreements have pages of definitions, set forth notification timetables which differ based upon the triggering event and create alternative methods for determining value, closing dates and financing. Much of this detail actually prevents business owners from successfully adopting the agreement – they get lost in the trees and no longer see the forest. While it may be easier for a lawyer to throw in a comprehensive, all inclusive template for lawyers to sort through, if the tool is not adopted or understood by the client, it offers no protection. We developed a “2 Page Buy-Sell” Agreement, which discusses the key aspects of the above in less than 2 pages, leaving the procedural components of the transaction, i.e. notice provisions, definitions, valuation dispute processes, to attached Schedules and Exhibits. This format does not lead to a shorter overall document, but it is much easier for business owners to review and adopt. Whether you consider a long form version or an easier to understand agreement, make sure you consider these issues in advance of having your partner’s ex-spouse, creditor or bankruptcy trustee as a partner.