Buy Sell Provisions
By Michael D. Cross, Jr., J.D.
As discussed in a separate article on this website entitled Starting a Business with a Partner, sharing ownership of a business with others can be quite beneficial, as it allows individuals to pool their capital, efforts, and expertise and devote themselves toward accomplishing a common goal. In any such enterprise, it is vitally important that these individuals, whom we will call “partners”, have a written agreement setting forth their understanding regarding ownership and control of their company. In the article referenced above, we discussed several considerations that should be addressed in this written agreement. This article will focus on the provisions of the agreement setting forth how partners can leave the “partnership.”
As a preliminary matter, however, it is important for us to note three things. First, although throughout this article we will refer to “partners” and “partnerships”, we are using these terms casually and not in their legal sense. The principles and ideas set forth in this article apply whether the business is organized as a corporation, limited liability company, limited partnership, or general partnership. Second, as a matter of practice, it is important to note that the owners should form a business entity such as a corporation or a limited liability company so as to limit the extent to which the owners’ personal assets are subject to business liabilities. (See Choice of Business Entity Considerations (Part I), also available on this website.) Third, although we will refer to the written agreement as a “partnership agreement”, depending on the type of business entity that has been formed, the agreement may be known as a buy/sell agreement, partnership agreement, shareholder agreement, or operating agreement.
Having previously discussed the operations and funding of the partnership, we must discuss the method by which partners can leave the business. This involves identifying the procedures the company and the departing partner must follow, establishing the price the departing partner will be paid for her interest, and setting forth the manner in which the price will be paid. Additionally, in a small business in which the owners must work closely together, it is important to make certain that any new partner is acceptable to and can work with the other partners. Accordingly, note that some provisions of ownership agreements are written in a manner so as to make transfer of an ownership interest more difficult.
Reasons for Departing
Consider first that a partner may leave the partnership because she wants to retire, becomes disabled, or passes away. Additionally, a partner may be dismissed from the partnership because she has failed to work on behalf of the business, or because she has committed fraud or other intentional or negligent acts that harm the partnership. In each situation, there must be a mechanism in place that sets forth the terms under which the partner must sell her interest upon departure.
The price paid for a departing partner’s ownership interest often varies based upon the reason for which the partner is leaving. Partners that retire in good standing after a long tenure with the partnership should receive more for their interest then someone who has been removed from the partnership in chains and shackles after stealing from the company. Terms of payment should balance the ability of the business to pay, considering the loss of the partner’s contribution to the revenues and the partner’s need for income.
Valuing the Business
There are several ways in which to establish the amount to which a departing owner should be entitled. Each starts with a valuation of the company. The basis of the valuation may be the owners’ equity as established on the balance sheet, a multiple of the gross revenue or net profit of the company, or the value of the company as established by an independent business evaluator. It may also be based upon a combination of these methods. Generally, companies whose business involves providing services to others without requiring substantial inventory or equipment (including computer consultants and professional service firms) base valuation on a multiple of gross revenue. A company whose business requires substantial inventory or equipment generally develop a valuation more closely tied to the company’s balance sheet, as this will be more likely to reflect the cost of doing business and the value of current assets. A company with multiple lines of business including the sale of both services and goods may require an independent evaluation of its values.
Choosing the appropriate basis for the valuation (along with the formula deriving a value from that basis) requires careful thought and considerable knowledge of the company and its industry. The owners of many privately held companies attempt to agree upon a formula based upon the balance sheet or gross revenue of the company so as to determine the valuation less expensively, as a comprehensive business valuation can be costly. As might be expected, it is much easier to reach agreement at the inception of the company rather then waiting for conflict to arise. Choosing the appropriate value is the most part of the buy/sell agreement. Unless the partners choose the proper formula, the partners and/or the company potentially could owe a great deal of money to a partner that wishes to leave, thus causing the company or the partners substantial financial difficulty.
Once a value of the company is determined, the amount to which a departing owner is entitled is based upon his percentage ownership of the company as well as the circumstances under which the owner is leaving. For example, some partnership agreements provide that the company may be valued either pursuant to a formula based upon the company’s annual gross revenue or upon shareholder/owner’s equity as determined by the balance sheet. If a person retires in good standing, she will be entitled to the greater of these two values plus a “retirement bonus” of an additional thirty percent. If she leaves in good standing prior to retirement, she will receive only the greater of the two values without the retirement bonus of thirty percent.
If an owner is fired because of poor performance, because they cannot get along with the other partners, or because they become insolvent or file for bankruptcy protection, they might receive the lesser of the two values. Finally, if a person is convicted of a felony or otherwise causes harm to the partnership, they may be required to surrender their ownership interest for a nominal amount.
These methods, which may vary considerably based upon the desires and agreements of the partners, are quite easy to calculate. Ease of use is their strength. From time to time, however, they may not reflect current market conditions. Accordingly, some partners establish alternate methods of valuation, including “Solomon’s Choice” provisions and rights of first refusal.
“Solomon’s Choice” provisions are best used when a company has two equal owners. Under such a provision, one owner, at any time, may offer to purchase the interest of the other owner. In her offer, she will set forth the terms, specifically including the price, under which she will buy the other owner’s interest. The owner receiving the offer then has the option either of selling his interest pursuant to the terms of the offer, or buying the offeror’s interest on the same terms. Use of this provision allows for the resolution of any potential impasse among the owners, but it may not work well if the owner’s have substantially different economic means. If one owner has substantially more resources than another, that owner can always acquire control by offering a purchase price that the other owner cannot pay.
A right of first refusal provision works in a different fashion and can work well without regard to the number of owners a company has. In such a situation, one owner (the “seller”) receives an offer from a person who is not an owner of the company. The seller then delivers the offer to the company, and the company has the option of purchasing the seller’s interest for the price set forth in the offer. If the company chooses not to purchase the seller’s interest, then the seller has to forward the offer to the other owners of the company. These owners then have the option of purchasing the seller’s interest pursuant to the terms of the offer by the outside party. The owners who elect to purchase the seller’s interest (the “purchasers”) generally must do so in accordance with their ownership interest in the company as compared with the other purchasers’ ownership interest in the company. If neither the company nor the owners elect to purchase the seller’s interest, then and only then can an outside party buy an interest in the company, and that purchase must be strictly in accordance with the offer previously presented to the company by the seller.
Terms of Payment
Once the price and the purchaser(s) have been established, the method of paying the price must be determined. Generally, the departing owner prefers to be paid for her interest immediately rather than over time so as not to incur the risk of default by the company or the purchasing owners during the time of repayment. The company or the purchasing owner(s) generally prefer to have the opportunity to pay the purchase price over time so as not to deplete the company’s cash reserves or require the company to take on additional debt. Often, the terms of the ownership agreement will provide that the company may, at its election, determine to pay the purchase price immediately or over a set amount of time. If the purchase price is paid over time, the agreement generally provides that the unpaid balance will accrue interest. Some agreements provide for the precise interest rate. Others provide for an interest rate based upon the prime rate of interest as set forth in the Wall Street Journal on the date of purchase.
Funding the Buy/Sell Agreement
It is possible to fund the purchase in certain circumstances. For example, many companies (or owners of companies) purchase life and/or disability insurance on each of the owners. The valuation and payment provisions of the partnership agreement are then drafted so as to contemplate the payment of a departing owner’s interest by the company from the proceeds of the insurance policy. Although insurance policies are not without cost, they often allow for the most cost efficient transfer of ownership interests upon the death or disability of an owner. Many owners strongly favor the use of insurance so as to make certain their families will receive a benefit from the company they have built. Most business attorneys have insurance professionals with whom they are comfortable working and to whom they will refer companies interested in funding a buy/sell agreement.
The considerations set forth above are quite general in nature and should not be considered legal advice, as appropriate recommendations cannot be made without consideration of specific information regarding the company and its owners. Rather, the intent of this discussion is simply to provide business owners with greater knowledge so they may understand the issues involved and decisions to be made in preparing an ownership agreement. For specific advice concerning these matters, please consult an attorney experienced in business matters.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.