A buy-sell agreement is like a prenup for a business: it helps you determine what will happen if an owner leaves.
No business partnership lasts forever. Inevitably, there will come a time when an owner needs to move on, either by their own choice or because of changing circumstances.
If you are starting a new business or are concerned about how future events may impact your existing business, it may be time to consult with a Michigan business attorney from the Miller Law Firm. We can help you plan for future contingencies that may affect your business.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a contract between owners of a business that governs what will happen if one of them finds it necessary to give up their interest in the business. Buy-sell agreements may address circumstances such as:
- Physical or mental disability,
- Malfeasance, and
- Voluntary departure.
These types of events are known as “trigger events” because they trigger the provisions of the buy-sell agreement.
When Should You Enter into a Buy-Sell Agreement?
It’s important to put a buy-sell agreement in place long before you ever need one. Ideally, this type of agreement should be part of your initial business plan. It will likely be easiest to reach an agreement if you set up a buy-sell agreement at the same time you establish your business. People are less likely at that point to have developed other interests that may affect their willingness to enter a fair contract.
Things to Address in a Buy-Sell Agreement
Buy-sell agreements operate to reduce uncertainty and avoid litigation. There are a number of things you may consider addressing in your buy-sell agreement.
The Effect of Specific Trigger Events
Buy-sell agreements start by defining the triggering events they pertain to. You may establish different procedures to address different trigger events.
For example, you may use one procedure to dispose of an owner’s interest at their death, another in case of retirement, and another if they choose to leave voluntarily. You might also list some circumstances where an owner may unilaterally withdraw from the business and others that require a vote of all the owners.
Some triggering events might permit the involuntary removal of an owner. For example, if someone commits fraud or harms the business in some way, your buy-sell agreement might provide a mechanism for other owners to vote the person out.
Your buy-sell agreement should attempt to address all circumstances that you can reasonably anticipate. A thorough agreement will provide a mechanism for you to quickly and predictably address triggering events.
Restrictions on Transferring Ownership
Buy-sell agreements frequently contain restrictions on transferring ownership interests in the business. These restrictions allow existing owners to avoid having to share ownership with unknown entities. These may include restrictions on:
- Gifting or passing an ownership interest to heirs;
- Pledging an ownership interest as collateral; and
- Selling or transferring an ownership interest.
While buy-sell agreements can place restrictions on the transfer of ownership rights, the restrictions have to be reasonable.
Right of First Refusal and Repurchase Options
To keep ownership interests from falling into the wrong hands, a buy-sell agreement may use a right of first refusal or a repurchase option. These options give existing owners the opportunity to retain a departing owner’s interest.
A right of first refusal applies when an owner wants to voluntarily sell their interest. For example, it may permit other owners to purchase the interest for a price equal to what a third party offers.
A repurchase option gives the remaining owners an opportunity to purchase another owner’s interest, even against that owner’s wishes, in case of certain triggering events. For example, if an owner loses their interest in a bankruptcy or divorce, a repurchase option may allow the other owners to purchase that interest back for a certain price.
How to Value the Business
Since many triggering events result in an option to buy out a departing owner’s interest, it is important to include a method of valuation in your buy-sell agreement. There are several approaches you may consider depending on your circumstances.
In some circumstances, you may consider stating the exact value to pay for a buyout in your buy-sell agreement. This approach makes the most sense for newer small businesses without a lot of value.
You may consider starting with an agreed value to avoid the cost of an appraisal. You can then renegotiate your buy-sell agreement later as your business grows to use a more precise calculation method.
Another approach is to use an agreed formula to calculate the value of the business. This method is simple and avoids the need for an appraiser, but it can also have limited accuracy.
Formulas are based on accounting methods. One common formula relies on the book value of the company, which is calculated by balancing the company’s assets and liabilities.
Another method is to apply a multiplier to other financial measures such as earnings or revenue. For example, a buyout could be equal to one-third of the previous 12 months’ revenue.
Although formulas are predictable, they do not take into account all the same circumstances that an appraiser might consider, such as market changes, history, and anomalies. Therefore, a formula may drastically overvalue or undervalue an ownership interest.
Market value at the time of the buyout
The most accurate method for calculating a buyout is to use the market value of the business at the time of the buyout. However, this method can be more costly, since it usually requires you to hire an appraiser.
Terms of a Buyout
In addition to outlining the method for calculating the amount of a buyout, buy-sell agreements generally include the terms for completing the buyout.
A buyout can be financially challenging for a business. It may not be feasible to buy out a departing owner in a lump sum.
Your buy-sell agreement can take these challenges into account by allowing for payments to be made over a period of time. Or it could give the existing owners a certain period of time to obtain financing for the buyout.
Get Started with Your Buy-Sell Agreement
If you want to learn more about establishing a buy-sell agreement for a new or existing business, contact the knowledgeable business attorneys at The Miller Law Firm. Our practice is dedicated to helping Michigan entrepreneurs build and protect their businesses. You can rely on our 25 years of experience to help you establish a strong foundation for your company.
Call us or contact us online today to learn more about how we can help you.