The Importance of Buy-Sell Agreements

Hillel Goldman

When businesspeople sit down with their lawyer to discuss setting up a new business, they’re usually thinking about all the great opportunities in front of them.  The promise of unlimited profits, financial independence, and working for themselves is what they see.  However, one of the most important issues that they need to examine, an exit strategy, is probably the last thing that they usually are thinking about.

When business lawyers attempt to discuss this issue with their business start-up clients, they walk a fine line for several reasons.   During the “dating/honeymoon” stage of new business ventures, the owners rarely want to think about such negative things as the death or divorce of their business arrangement.  Additionally, addressing such negative issues as death, disability, dispute resolution, spousal interference, and business failure are not viewed as positive karma by most new businesspeople.    Finally, the thought of paying a lawyer to create yet another document that will never be needed is usually a pretty distasteful thought to most business owners.

Perhaps the most and important document that a business lawyer can prepare for business clients is the buy-sell agreement. Unfortunately, it is also one of the most difficult business documents to prepare properly.

Buy-sell agreements serve several important functions.  First, they provide a mechanism to preserve the close ownership of the entity by restricting how the ownership interests (stock, membership interests, etc.)  can be transferred.  Second, they provide a market for the ownership interests of a closely-held business.  Third, they provide the business owners with an agreed upon method for valuing their ownership interests.  Fourth, in the case of S Corporations, they should provide protections from doing things that could terminate the corporation’s S election.  Fifth, in the case of limited liability companies and S Corporations, they can provide a mechanism to ensure that owners receive enough actual annual distributions from the business to pay the taxes that are attributed to them.  Sixth, they can be used to allocate entity control among owners and management.  Seventh, they can be used as an estate planning tool.

Each of these functions is extremely important to the ensure that business owners have a road map for dealing with these important issues before they become serious problems.  Although most business owners don’t want to address mortality (theirs or the business), permanent disability, termination of employment, and business disputes, it is much easier to deal with them upfront when you’re not actually living through them.

Having a buy-sell agreement provides business owners, their lawyers, and in those serious cases where the parties are unable to resolve disputes on their own, judges and juries, with a framework for dealing with these difficult issues.  It also, provides the parties with an exit strategy if business issues cannot be addressed satisfactorily by the parties.   Therefore, it serves as a business prenuptial agreement for the parties.  In the litigious society in which we live, having a buy-sell agreement will not necessarily prevent litigation when disputes occur, but at least it provides a mechanism to try to resolve the issues.

There are three types of buy-sell agreements.   First, there is the redemption agreement where the entity is required to purchase the departing owner’s interest.  Second, there is the cross-purchase agreement where the remaining owners are required to purchase the departing owner’s interest.  Third, there is the hybrid agreement where the departing owner’s interest is first offered to the remaining owners and if they choose not to purchase the departing owner’s interest then the entity is required to purchase this interest.

Determining what type of buy-sell agreement is appropriate requires extensive time and planning.  The tax consequences to each owner and the entity must be considered.  Additionally, such non-tax issues as the complexity of the agreement, ownership issues and restrictions, and life insurance questions must be examined.  There are also ethical issues that need to be addressed related to what the lawyer’s role is in preparing the agreement and who the lawyer actually represents since each of the parties (the individual owners and the business itself) have differing interests.

The need for a buy-sell agreement is therefore not only a tough concept to sell to business start-up clients, but it is also a difficult job for the owners and business lawyers to perform together properly.  However, this investment of time and effort is invaluable in providing an important tool to assist the owners in their attempt to assure the successful operation of and exit strategies for their business.