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Issue 42 – July, 2023

The 23 D’s of Buy/Sell Agreements

By Daniel A. Prisciotta, CFP®, CPA*, PFS, ChFC®, CBEC®

When a business has multiple owners, it is critical to have a well thought out, comprehensive buy/sell agreement. Such an agreement protects the owners, their families, and the business itself. In fact, the lack of an agreement or omission of any of the following “D’s” could result in legal disputes, estate issues, financial challenges and even failure of the business.

A well-drafted buy/sell agreement should address each of these D’s. Which ones does your agreement address?

  1. Departure – An employee quits and leaves employment. When a shareholder leaves, whether for regular retirement or early voluntary retirement, someone should purchase his/her stock.
  2. Discharge – An employee may be discharged and the buy/sell agreement is triggered.
  3. Death – This problem can be compounded if the surviving shareholders have to take in a new partner, the deceased owner’s spouse and/or children.
  4. Divorce – It would not be unusual for a spouse to end up with one half the stock of a closely held business in the event of a divorce.
  5. Disability – Many agreements ignore what could be a more serious financial drain: disability (the “living death”).
  6. Determination of Value – Owners would want to be sure they or their family received fair or equitable value in the event of a living buyout or death. The value will affect the estate of the decedent, as well as the recipient of proceeds.
  7. Disqualification – Addressing the loss or suspension of a particular license or designation that is required to be held in order to practice certain occupations or hold ownership. For example, if an owner is rendered disqualified to practice medicine by regulators, the other shareholders may desire that such disqualification be considered a trigger event for the buy/sell agreement.
  8. Disaffection – Sometimes owner-employees quit in place and need to be discharged.
  9. Disagreement – If equal owners come to a major disagreement, the business can become “deadlocked” and unable to further conduct normal operations. If ownership is unequal, and there is a major disagreement, a minority shareholder could be forced out of active employment. Interestingly, when we ask groups of people what the most common triggers for buy/sell agreements are, they almost always place divorce and disagreement (or deadlock) as first and second. However, many buy/sell agreements do not address the potential issue of disagreement or deadlock. Should yours?
  10. Disclosure – The shareholders’ agreement may need to address the need to maintain confidentiality of competitive information and intellectual property. This is important at all times, of course, but even more so in the event that a shareholder departs, for whatever reason.
  11. Dispute Resolution – The parties to an agreement may want to provide for specific procedures in the event that otherwise irresolvable disputes arise. The parties may agree, for example, that certain disputes are to be resolved through binding arbitration, as well as the procedures for setting up and paying for the arbitration process.
  12. Dilution – When corporations sell or issue additional shares, the ownership percentages of existing shareholders may be diluted. The shareholders may want to agree in their buy/sell agreement on procedures to protect against their being diluted by the issuance of new shares. Such provisions would prevent a share issuance without notice and would provide the affirmative opportunity to participate in the issuance pro rata to their ownership.
  13. Dividends – It may be appropriate to agree on dividend policy, particularly in early or growth stages of a company’s life, or when the company has debt outstanding. If agreement is not reached in the formative stages of a business, then dividend policy will be determined by the controlling shareholder or group of shareholders that exercises control.
  14. Distributions – If the company is an S corporation or LLC (pass-through entity), it is a good idea to document an agreement to make distributions to shareholders, at a minimum, for their pro rata share of personal taxes generated by income at the entity level.
  15. Drag-along Rights – A controlling shareholder may desire to have what are called “drag-along” rights. If, for example, he obtains an offer for his shares representing 75% of the stock, he may wish to be able to force (by agreement, of course) the remaining 25% of the shares to sell with him. This might occur when a buyer would purchase not less than 100% of the shares.
    • Tag-along Rights. While not a D, the corollaries to drag-along rights are known as “tag-along” rights. With a tag-along provision, the minority shareholders can force (by agreement, of course) the majority shareholder to arrange for the sale of their shares at the same time and for the same price and terms as the controlling shareholder receives. This would prevent a controlling shareholder from selling only a control block, leaving the remaining shareholders in a minority position with a new and unknown owner.
  16. Double Entities – Many owners of companies desire to separate the ownership of real property from the operating company. The purposes for this separation can be to protect the property legally, to provide a separate entity for estate planning purposes, to isolate financing arrangements, and many others. If there is parallel ownership between operating company and a real estate entity, it may be appropriate to have parallel terms in their respective buy/sell agreements.
  17. Differential Pricing – Sometimes owners agree to differential pricing for purposes of their buy/sell agreements depending upon circumstances of the triggering event (or departure). Assume there is a price for purposes of the agreement determined by appraisal or the “Purchase Price.” The following are certainly not recommendations, but are illustrative of what might be agreed to by the owners:
    • Death – 100% of the Purchase Price.
    • Retirement – 100% of the Purchase Price.
    • Terminated without cause – 90% (or 100%) of the Purchase Price.
    • Terminated with cause – 80% of the Purchase Price.
    • Quit or terminated and competing with company – 75% of the Purchase Price.
  18. “Don’t compete” Agreements. The shareholders may have noncompete agreements in the ordinary course of business. However, the buy/sell agreement could require that a noncompete agreement be signed (reasonable as to length and geography) in the event of a purchase of shares pursuant to the agreement. Noncompete agreements are of sufficient importance to need additional discussion below.
  19. Donate – The buy/sell agreement may specify under what circumstances stock can be given to spouses, children, charities, etc.
  20. Distributions after a trigger event – What happens to dividends or distributions during the period of time when a buy/sell agreement is triggered and when the purchase transaction is completed? This question is important when disagreements arise, and many months or years go by before there is resolution.
  21. Default – In most closely held corporations, the individual shareholders must personally guarantee corporate loans from banks and/or contribute payments to the bank or business. This addresses situations involving personal bankruptcy and other involuntary transfers. The corporation and remaining shareholders will want to protect against having a bankrupt owner’s shares falling into unfriendly hands in the bankruptcy process.
  22. Disaster – Contingency plan for dealing with potentially devastating events that could destroy a business – data loss, building fire/flood, terrorist acts, strikes, etc.
  23. Dissolution – When the decision to end the business is mutual and no buyer is present, then methods of splitting up property, clients, receivables, payables, etc…could create problems.

There are a number of other situations that might warrant consideration in your buy/sell agreement that don’t begin with the letter D. These include:

  • Rights of first refusal. It is common for buy/sell agreements to contain rights of first refusal to the company, to the other shareholders, or to both.
  • Optional purchase/sale. The buy/sell agreement can be optional for the company, the shareholder, or both to buy or to sell. Note than an optional agreement will not specify a completed transaction upon the occurrence of a triggering event.
  • Mandatory purchase/sale. The agreement calls for mandatory purchase of shares after a triggering event (by the company or the other shareholders at the agreement price and terms) and the mandatory sale by the affected shareholder. Unless a buy/sell agreement is mandatory on both seller and buyer, it does not specify a completed transaction with certainty. Agreements are sometimes made to be optional to ensure “flexibility.” This flexibility comes with a high price, both for a company and its shareholders.
  • Life insurance. If there is life insurance on the lives of owners, the agreement should specify exactly how any proceeds are to be treated in terms of valuation of shares.
  • Maintenance of S corporation status. The agreement may prevent any shareholder from taking any action with respect to the shares that would jeopardize the S corporation election.
  • Who owns the stock after a trigger event? This is a question that is seldom addressed but is of vital importance. The basic question is the following: After a trigger event, does an affected shareholder retain the rights and privileges of ownership (to vote, to receive distributions, to receive financial information, etc.), or are his shares converted into a right to receive the Purchase Price (or whatever term is used) pursuant to the terms of the buy/sell agreement?
  • Control maintenance. Many companies are owned by individuals or families. Their buy/sell agreements may call for provisions that maintain the relative ownership of the respective families when stock transactions occur.
  • Vote restrictions or agreements. The owners of a business may agree to vote collectively on certain issues. It could be a provision that upon departure of a shareholder and prior to his shares being purchased, the shares are automatically converted to nonvoting shares.
  • Personal guarantees.  Sometimes shareholders who are subject to a buy/sell agreement provide a personal guarantee of corporate debt. They may desire that the corporation and other shareholders agree to take all necessary actions to remove (or to attempt to remove) an owner from the personal guarantee if he or she ceases to be a shareholder. What happens if the lender calls in a loan following the death of a guarantor? How much of a cash flow strain will this place on the business and remaining shareholders?

Bottom line: If your clients don’t have a comprehensive, up-to-date buy/sell agreement, make it a priority. If they currently have one, but you’re not sure if the 23 D’s (and other provisions described above) are properly addressed, a review by a qualified professional is necessary to protect your client, their business, and their family.