I Organizing the Business: Buy-Sell Agreements

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1 I Organizing the Business: Buy-Sell Agreements CLIENTS FORMING OR ACQUIRING businesses devote a substantial amount of time and attention to many matters, each of which is critical for the success of the endeavor. Relations with financing sources, the selling parties, suppliers, customers, employees, and other parties, together with refining the business plan, justifiably receive a considerable amount of the business owner s focus in this process. Invariably, at the end of the business formation process, a client will offhandedly remark (without acknowledging the careful lawyer s constant reminders from the inception), Oh yeah, we need a buy-sell. PRELIMINARY CONSIDERATIONS A buy-sell agreement ( BSA ) can mean many things to different people. It is perhaps the most important document in outlining the relative roles and rights of the parties, insuring smooth relations over a long period of time and attempting to maximize long-term personal and business planning strategies. Like the foundation of a very expensive house, the agreement is frequently overlooked and unappreciated. However, it can provide the cornerstone of a successful business enterprise and personal relations and serve as a bedrock during turbulent times. Moreover, discussion of many of the thorny issues to be contained in a BSA will give each partner a sense of how their partners think about and react to certain situations and concepts. The Basic Issues This article provides an overview of the many aspects of inter-owner agreements to sensitize both the lawyer and businessperson to the many different issues to discuss in forming a business or bringing in new owners to the business. The principal items discussed in this article are: The main purposes of BSAs; The situations in which a BSA arises; The nuts and bolts, as well as nuances, of transfer restrictions, management, and control provisions; Dealing with cases of deadlock and possible unwinding; Capitalization of the business; Enforceability of BSAs; and Termination. 1

2 Although every issue discussed in this article is not absolutely critical for business survival, these topics provide a strong basis on which to build and maintain a strong enterprise. The article also will identify sensitive tax issues that pervade the considerations underlying these agreements. The reader should be cautioned not to rely on the tax conclusions, only be sensitive to the issues raised. Further consultation with competent tax counsel is essential. Flexible Terminology Although BSAs are frequently discussed in the context of a corporation, many of the principles and rationales apply with equal force to other forms of business enterprises such as limited partnerships and limited liability companies. Therefore, for purposes of consistency and simplicity, this article will use the term inter-owner to refer to relations between the owners of a business in the appropriate context. For simplicity sake, the terms shares or ownership interests will be used interchangeably to mean any ownership interest in a business, whether shares of stock, partnership interests, membership interests in a limited liability company or otherwise, and company will refer to all forms of business entities. Lawyer s Dual Role The parties should understand a lawyer s sometime dual role and inherent conflicts in representing one owner and the entity, or representing many owners. As a general rule, attorneys may represent the business and multiple owners in preparing a BSA. The lawyer should advise those receiving the dual representation of the potential conflicts and obtain the clients consent. Notwithstanding the obtaining of consent, the ABA Model Rules of Professional Conduct further require that the attorney reasonably believe that representation will not adversely affect the relationship with the other client. The Official Comments further state that there may not be a serious conflict if the clients are generally aligned in interest, even though there is some difference of interest among them. The conflict becomes more prevalent when there is a clear majority versus a small minority. PURPOSES OF A BUY-SELL There are many well-intentioned goals that a well-drafted BSA achieves. Some factors will invariably be more important than others depending on the type of business situations. Predictability and Continuity of Ownership 2

3 A well-crafted BSA provides a clear and precise road map regarding the ownership of the business and, in many cases, the management thereof. Absent a BSA, businesses would face ownership transition issues at the worst possible time at the death or other departure of key executive personnel. A BSA cannot remove the issues of replacing departing executives or investors, but it can at least minimize the risk of the uncertainty over how and under what conditions the shares will be disposed of or retained. Orderly Transfer of Ownership Somewhat related to the benefit of predictability and continuity is the orderly transfer of ownership. Restrictions on transferability of shares can minimize the chances that a business could be disrupted or held hostage by the sale or threatened sale of a block of stock to an unwanted suitor or even a competitor or by a dissident block. A right to buy employees shares upon certain circumstances also creates a sense of balance and order. As will be discussed in more detail below, a BSA should attempt to strike the delicate balance between a financial owner s desire to monetize its investments in a reasonable period with key executives desire not to financially impair the business or sell out too soon. In family businesses, a BSA should also strive to provide a means for family members participating in the business and those not participating in the business to structure their relationship. Create a Market for the Ownership Interests Most BSAs involve privately held businesses. The ability to resell shares or other indicia of ownership interests of these businesses may be legally restricted or impractical. BSAs ameliorate this liquidity problem by providing business owners a way to sell in a variety of circumstances. Establish a Fair Price for the Shares Valuing closely held businesses is more an art than a science. BSAs can provide a known, objective, and definable means of valuing the seller s shares depending on the circumstance of departure. Protect Minority Owners Means of oppressing minority owners of businesses are beyond the scope of this article. BSAs assist in limiting some classic devices majorities use against minorities. For example, BSAs may require distributions to be made to all owners in a minimum amount equal to their putative income tax 3

4 liability based on the business s net profits for the year. Absent such a provision, the minority owner in a pass-through entity would have phantom income but no cash to pay the taxes. BSAs could also give rights to minority owners to have supermajority and other voting rights to provide disproportionate input, to limit salaries and other payments to the majority, and to sell their shares at various intervals. Protect Majority Owners BSAs can also protect majority owners from the intransigence or hindrance of minority owners. These minority owners may not be active in the business, have supermajority protection rights, ask many questions, or simply not share the same philosophies regarding the direction and goals of the business. BSAs may devise means by which majority owners may purchase the minority s interests and limit the amount of involvement and information to which the minority is entitled. Tax Considerations Many tax considerations justify entering into BSAs. As noted above, tax items are generally beyond the scope of this article, and will only be discussed sketchily. Preserve S Corporation Status A corporation will lose its eligibility to remain an S corporation if transfers of its stock are made to disqualified shareholders. BSAs will prohibit such transfers. Provide for Amount and Timing of Distributions In pass-through entities, taxes on the net income will flow through to the individual owners. As discussed above in a different context, BSAs should provide a mechanism to assure that distributions are made to pay such taxes. Assist in Setting Values for Estate Tax Purposes The Internal Revenue Service ( Service ) and applicable state counterparts will scrutinize values placed on the shares of closely held businesses in a decedent shareholder s estate. A BSA will give some degree of credibility to the valuation methodology. The IRS will respect the values determined in accordance with the BSA in most cases if non-family 4

5 members are also parties to the BSA, since their presence shows an arms length bona fide agreement. Provide Liquidity To Pay Estate Taxes Many times a business owner s biggest asset is her shares in a closely held business. While tax laws provide for estate tax deferrals or installment payment of taxes in certain circumstances as will be addressed below, BSAs provide a means to monetize this asset to generate funds to pay these taxes. TYPICAL SITUATIONS NECESSITATING A BSA BSAs are appropriate in virtually any business with multiple owners. Like Tolstoy s observation about happy families being happy for the same reasons and unhappy families being unhappy for different reasons, it is never quite clear while drafting BSAs which provisions will be applicable or even necessary, as the relationships between or among the parties has yet to develop. BSAs will be appropriate in family owned businesses, businesses when two or more families are co-owners, when some family members are involved in the business and some are not, a business owned by an unrelated management team financed by an unrelated investor, and strategic ventures between corporate owners. RESTRICTIONS ON TRANSFERABILITY OF OWNERSHIP INTERESTS Restricting transferability of shares is a central feature of BSAs. Although general legal principles descry alienation and restricting transferability of property, most courts and state laws have upheld restrictions in the context of BSAs for several reasons in addition to those set forth above. First, restricting transferability forces business owners to work together and stay in business with their original associates. Transfer restrictions also serve to balance an owner s desire for liquidity and reaping the fruits of the owner s labors with the desire for stability, order, and predictability. Finally, transfer restrictions are imposed under federal and state securities laws, and any sale of securities needs to be analyzed to assure compliance with securities laws. Purchase of a selling owner s shares is accomplished in one of three ways: the business redeems the shares, the other owners purchase the shares, or a hybrid combination of both. Redemptions The redemption of the departing owner s shares by the business is straightforward and easy. There is one buyer and one seller. In a cross- 5