Let's take a moment to celebrate the start of (a non-Leap Year) February. We have just 28 short—and I mean short—days until March. That's one month closer to warm weather, vaccinations, graduations, summer weddings, baseball, music festivals, campfires, and maybe a time when the actual will replace some of the virtual. In the meantime, I'd like you to take out your family business's buy-sell agreement and read it. Yes, let's do this now, because you don't want to do it later, when you could be out having fun.
Many buy-sell agreements are not particularly well tailored to the circumstances of a family business. Buy-sell agreements are long and dull, and they contain a lot of language that people often dismiss as "boiler plate" (i.e., provisions that often are the same in every contract). Buy-sell agreements, however, are extremely important to a family business. It is worth the time and effort to get them right. For a family business, a buy-sell agreement should balance the interests of the ownership group versus reasonable rights for individual owners.
What is a "buy-sell" agreement?
A buy-sell agreement is an agreement among the owners of a closely-held company that governs the terms under which an individual owner may sell his or her ownership interest, and the rights or obligations of the company or the other owners to buy an individual's ownership interest. For a limited liability company, a buy-sell agreement is usually embedded in the company's operating agreement (a/k/a LLC agreement), which also contains provisions about company governance and management. Similarly, for a corporation, a buy-sell agreement is sometimes embedded in a shareholders' agreement, which also may contain provisions about company governance and management.
A good buy-sell agreement for a family business balances two competing interests. It restricts transfers of ownership interests, but it also provides reasonable opportunities for individual owners to withdraw from ownership.
Why should a buy-sell agreement restrict transfers of ownership interests?
For a family business, a buy-sell agreement can restrict transfers of ownership interests by limiting who may become an owner. This has many advantages. It empowers the managers to operate the business consistent with the family's shared principles and values. (In this context, the word "managers" refers collectively to the directors and officers of a corporation or managers of an LLC.) It allows family members to have preferred access to employment and career opportunities in the business. It ensures that the value created by the collective efforts and hard work of the family members in the business will accrue to the people they love.
Further, an unwanted owner in a family business can be disruptive in many ways. A minority owner, as owner, may not owe any duties to the business or the other owners. For example, it would be possible, theoretically, for a minority owner to exercise his or her voting rights in favor of positions that might harm the company or other owners. If a particular proposal requires consent of all or a supermajority of outstanding owner interests, a hostile minority owner might, in effect, hold a veto that could continually frustrate such proposals.
In addition, minority owners may have statutory rights to demand accountings, production of books and records, or a valuation of the business. A hostile minority owner may have standing to attempt to bring a lawsuit (a derivative action) against the company's managers at the company's expense.
Why should a buy-sell agreement allow owner exits?
For all the reasons described above, it makes sense in a buy-sell agreement to prevent an owner from transferring ownership interests to a person outside the family. If transfers of ownership interests are restricted, however, an individual owner may be unable to sell his or her ownership interest at a fair price if he or she wants to withdraw from ownership. Therefore, a buy-sell agreement should allow individual owners to exit ownership under terms that are fair to the owner, but are not disruptive to the business.
In recognition of the cycle of life, most buy-sell agreements require the business or the other owners to purchase the ownership interest of an owner who has died or become disabled. Such transactions can be funded (at least to some extent) with insurance, and they can help ensure that the departed owner's spouse and children will receive cash resources when they may need them most.
A well-balanced buy-sell agreement, however, should address other times when an individual owner might wish to withdraw from ownership. For example, an individual owner who is not employed in the business may wish to seek economic opportunities in other ventures, different industries, or distant geographic areas, or an individual owner may have good faith concerns about how the family business is being managed. In some family businesses, the owners are expected to personally guaranty business debt. An individual owner may not want to continue to put his or her personal assets at stake if he or she believes the business is taking on too much risk or has a flawed business plan
When an individual family member wants to exit ownership but has no reasonable prospect of selling his or her ownership interest, he or she can become hostile and, even as a minority owner, can create some of the disruption described above. It is better, therefore, if a buy-sell agreement can anticipate and accommodate owner exits that do not arise out of death or disability.
For example, the buy-sell agreement could allow a family member who holds a small amount of ownership interest to sell his or her interest back to the company in exchange for payment over time, or the buy-sell agreement could allow any individual owner the opportunity, from time to time, to sell a portion of his or her ownership interest back to the company or to other owners, with limits on the aggregate amounts that the company or other owners may be required to purchase at any given time. (An owner's right to require the company or ownership group to purchase his or her interest is called a "put" right.)
Put rights can be stressful for a family business, because, when they are exercised, they can require the business to part with precious cash, even if the purchase price is to be paid over time. If the existence of put rights are incorporated into the culture and budget of the business, however, the business can plan accordingly and maintain the resources needed to satisfy the put rights when they may be exercised. Further, the buy-sell agreement can impose a discount on the purchase price of ownership interests that are purchased pursuant to a put right, in recognition of the fact that the business is expending cash to accommodate an owner's voluntary decision to withdraw.
A good buy-sell agreement for a family business can keep out unrelated owners who might be hostile to the family, but it should allow some exit opportunities so that it doesn't create hostile owners within the family.