Should the Last One Standing Win?

An Executive Briefing on Buy-Sell Agreements

Without advance planning, interesting soap operas can occur – the aftermath of a business version of "Russian Roulette." Even among the best of friends or family, a mad scramble can ensue between the family of the departed and the remaining owner, often threatening the business itself. Advance planning, with an appropriate buy-sell agreement, can address or minimize the mayhem. For this reason a buy-sell agreement is a crucial component of business and estate planning when a business is owned by more than one person. Aside from an owner's death, what happens to the business if one of the owners becomes disabled or simply wants out? Addressing these questions is particularly appropriate in the context of a discussion on buying and selling businesses generally. Although considerable attention is paid to the details of the purchase or sale, often the buyers pay too little attention to contingency planning for things that might happen "down the road."

Developing an appropriate buy-sell agreement depends on the purposes and objectives to be achieved. Before the agreement can be drafted, the owners of the business must make a number of decisions, including:

(1) what circumstances should trigger a buy-out obligation,

(2) whether the buy-out will be mandatory or permissive,

(3) whether the buy-out should be by the company or other owners,

(4) what the buy-out price should be and how it should be paid, and

(5) whether life insurance funding should be obtained. Among the key factors to be considered in these decisions are the tax effects on the seller, the company and the remaining owner(s).

A buy-sell agreement is a contract among a corporation and its shareholders (or a limited liability company (LLC) and its members or a partnership and its partners) which provides for the purchase or sale of a business interest upon certain specified contingencies. The business interest involved may be corporate shares, an LLC membership interest or a partnership interest. For convenience, the business interest referred to throughout this article will be corporate shares.

For instance, the agreement may provide for the sale of corporate shares upon the occurrence of one or more of the following events:

• Death of a shareholder.

• Disability of a shareholder.

• Termination of employment of a shareholder, by retirement or otherwise.

• Involuntary transfer such as bankruptcy, attachment by creditors, etc.

• Attempted voluntary transfer by a shareholder.

• A shareholder deadlock or general incompatibility of shareholders.

The parties to a buy-sell agreement should specifically detail their true intent, both to avoid confusion and to ensure enforceability of the agreement by the courts.

Buy-sell agreements may have a number of objectives. The main objective typically is to provide for continuity and predictability of control of the closely-held corporation. The principal shareholders of such a corporation often do not want outsiders or spouses of their partners to acquire any interest in their corporation, so they seek to restrict the transferability of the shares and provide for an orderly transfer of the shares upon any one of the occurrences discussed above.

Second, buy-sell agreements may be drafted with the objective of providing liquidity to the selling shareholder or the shareholder's estate. Typically, the shares of closely-held corporations are not readily marketable. Without the buy-sell agreement, the shareholder who desires to sell may not be able to readily find a buyer, or, perhaps more accurately, a buyer acceptable to the remaining shareholder or shareholders. In this respect, the buy-sell agreement serves as an estate planning tool, providing the estate a means to turn the shares into cash and avoid leaving the estate with a valuable asset yet without sufficient liquidity to pay estate taxes and administration expenses. Life insurance and other funding techniques can be employed to ensure that resolving the shareholder's liquidity problem does not create a liquidity problem for the company or the remaining shareholders. Buy-sell agreements also can be helpful in establishing the value of a deceased shareholder's shares for estate tax purposes.

A buy-sell agreement might also be used to preserve a corporation's election to be treated as an S corporation, or to provide a mechanism for a break-up of the company upon a breakdown in relations between principals. The goal in the latter case is to get the parties to agree to as many terms as possible while relations are positive, recognizing that compromises are much harder to reach when relations break down. The buy-sell agreement can also be used to address the issues raised by the disability or retirement of one of the principals.

Finally, even if you could miraculously be assured that you would be the last one standing, that may not be a good thing. If the company is struggling, you could be the last one standing on a sinking ship.

Richard Thrapp serves as Deputy Managing Partner at Ice Miller LLP and previously served as Co-Chair of the Firm's Corporate Mergers and Acquisitions Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.