Buy-Sell Provisions: More Than Just an Emergency Plan

Regardless of the type of entity, every business has or should have (more on the should aspect below) a governing document that is at least a basic agreement among its owners that governs (1) the operation of the business and (2) the owners’ contractual rights, obligations, and restrictions with respect to their ownership interests in the business. The second of these contains what are commonly referred to, by lawyers at least, as the “buy-sell” provisions. If for some reason the owners decide not to enter into a written governing document, then the statutory default provisions of the business’s state of formation (which vary from jurisdiction to jurisdiction) automatically govern the entity and the owners. For example, if an owner of a limited liability company is determined to be legally incompetent to manage their affairs and the business either doesn’t have a governing document or that document is silent as to the treatment of an owner’s interest in the event of legal incompetence, what happens? Under Delaware law, the most widely recognized state of formation for businesses, the owner’s personal representative can effectively step into the owner’s shoes as an owner, thereby resulting in a previously unrelated (and likely inexperienced) third party having an active ownership interest in the business.

Despite these types of default provisions in statutes, many startups and family businesses are reluctant to set aside the time and resources (primarily financial) to put together a comprehensive agreement with buy-sell provisions to address all the “What if?” questions that life might decide to throw their way. Sure, everyone is rowing in the same direction now and the vision for what the future of the business will look like is generally set, and that’s great; but, as the age-old attorney question goes, “What happens if one of you gets hit by a bus?” Although it’s a completely valid question (*winking* otherwise we wouldn’t be asking, right?) and one that certainly warrants an answer, it can put people in a disaster-centric mindset. That mindset tends to lead them to approach buy-sell provisions as a sort of disaster planning roadmap rather than as what it really is – a plan to help secure the future of the business.

Instead of thinking of buy-sell provisions as an emergency plan, think of them in terms of wealth management and succession planning. Start by asking yourself this: is the sole purpose of estate planning to exercise one last measure of control over your assets in the wake of the ultimate personal disaster or is it really about ensuring the effective transition of generational wealth and securing your family’s future? My guess is that for the vast majority of business owners it’s the latter (we all know there are at least some people who can’t resist the temptation of the former). If so, we can safely presume that’s the motivation behind so many people utilizing estate planning early and often throughout their lifetimes rather than simply waiting to do something until they feel it’s necessitated by external factors (age, health concerns, market fluctuations, etc.). Buy-sell arrangements should be thought of in the same light. If you’re not willing to wait for external factors to dictate your other wealth management and succession planning, why wait for them to dictate your business planning? The short answer is you shouldn’t.

Besides avoiding the potentially unintended consequences of default provisions in entity statutes such as the one above, buy-sell provisions are important for businesses of all shapes, sizes, and stages to ensure an effective transition of ownership and control and, of course, to put guard rails in place for any bumps along the way. Because buy-sell provisions are largely a product of contract law, owners are generally free to negotiate and agree on a plan that encompasses everything from when and to whom an ownership interest can be sold to how taking the business public would be handled and everything in between. While this flexibility can mean that there is no “standard form” of buy-sell agreements, it also means the buy-sell provisions can be amended or modified by the owners over time to adapt to the ever-evolving needs and nature of the business and their shared plan for it.

Some of the more common buy-sell provisions that are particularly useful for small businesses are:

• Rights of first refusal granting existing owners the opportunity to purchase, or cause the business to purchase, a selling owner’s interest in lieu of a sale to an unrelated third party;
• Drag-along rights granting the majority owner(s) the right to pull a minority owner holdout into a sale of the business to a third party;
• Tag-along rights granting the minority owner(s) the right to join a sale of the business by the majority owner(s) to a third party despite not being part of the initial negotiations;
• Redemption provisions granting a right to or requiring the existing owners to purchase, or cause the business to purchase, the interest of a deceased owner, an owner whose marriage is dissolving, an owner who becomes legally incompetent/disabled, or an owner filing for bankruptcy in lieu of allowing an involuntary transfer of the owner’s interest to a third party as a result of any of the foregoing;
• Redemption provisions granting a right to or requiring the existing owners to purchase, or cause the business to purchase, the interest of an employee owner terminating employment with the business; and
• Sale terms and conditions pre-determining the valuation method (including, if desired, any discounts), payment method, and payment timing for the purchase of an owner’s interests under the buy-sell provisions.

The point: all business owners, even early-stage entrepreneurs, should consider utilizing buy-sell agreements as a means of securing the future of their business, irrespective of its perceived size, sophistication, or value.