Characteristics of Companies with Buy-Sell Agreements
Companies that most need and most frequently employ buy-sell agreements tend to share the following characteristics:
- They have substantial value. There are many hundreds of thousands of businesses that might be categorized as “mom and pop” enterprises, and generally do not attain significant economic value. The focus of this discussion is on businesses of substantial value, or those with as low as a few millions of dollars of value and upwards to many billions in value.
- They are privately owned. When there is an active public market for a company’s securities, there is generally no need for buy-sell agreements. Note that these considerations of buy-sell agreements also apply to joint ventures involving one or more publicly traded companies where the joint ventures themselves are not publicly traded.
- They have multiple shareholders. Most businesses of substantial economic value have two or more shareholders. The number of shareholders may range from a small number of founders or initial investors to many dozens, or even hundreds, of shareholders in multi-generational and/or multi-family enterprises.
- They likely have shareholders who are active in the business.
- The corporation is a party to the buy-sell agreement, unlike with many smaller businesses, which may have cross?purchase agreements between the owners.
Over the last thirty or so years, I have had the opportunity to read hundreds of buy-sell agreements. The issues considered and the terms included in buy-sell agreements tend to address issues flowing from the above common characteristics, rather than industry-specific issues. One reasonable inference from the characteristics listed above is that they cross industry boundaries and relate to all businesses with similar characteristics.
One of the principal benefits of buy-sell agreements is limiting who the other shareholders might work with. Companies with active shareholder-owners are highly likely to have buy-sell agreements.
Buy-sell agreements are necessary and/or appropriate for all corporate forms, including:
- Corporations, whether organized as S corporations or C corporations
- Limited liability companies
- Partnerships, whether between individuals or between entities, such as corporate joint ventures
- Not-for-profit organizations, particularly those with for-profit activities
- Joint ventures between organizations (quite often overlooked)
Mezzullo on Objectives of Buy-Sell Agreements
My views are generally consistent with others who have written extensively on the use of buy-sell agreements. For example, one nationally recognized authority in this area, Louis A. Mezzullo, outlines some of the benefits of buy-sell agreements in a publication of the American Bar Association.
Footnote: Mezzullo, Louis A., An Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business Second Edition (Chicago, IL, ABA Publishing, 2007). The outline for the following discussion is provided by Chapter 2 of this book, “Objectives of Buy-Sell Agreement.” The book (and the first edition published in 2001) is published by the Section of Real Property, Probate and Trust Law of the American Bar Association.
Mr. Mezzullo writes about the objectives of a buy-sell agreement for entities, for a deceased owner’s estate, for a retired or disabled owner, and for all remaining owners. The following summarizes his discussion in outline form.
Objectives for entities, including all common forms of corporate organization, include:
- Prevent unwanted third parties from acquiring ownership.
- Impose restrictions on transfer.
- Void transfers that might result in the loss of an entity’s S election (or other tax pass-through status).
- Provide for transfer of ownership and/or control on a planned basis.
- Provide a means of funding share repurchases.
- Provide an independent pricing mechanism for transactions independent of the potentially divergent opinions of the owners.
Objectives for a deceased owner’s estate include, with some overlap:
- Establish a favorable “market” for otherwise illiquid securities.
- Ensure that the estate obtains cash for the payment of the purchase price (or cash and notes) so that estate administration will be facilitated.
- Protect the estate from having to negotiate price from a point of potential weakness in bargaining power.
- Establish the value of the ownership interest for federal estate tax purposes.
- Relieve the estate (or its beneficiaries) of ongoing responsibilities with a business.
- Facilitate timely administration of estates.
- Provide for timely infusion of cash to an estate.
- Prevent disputes among the beneficiaries of an estate regarding ownership of the stock (by causing its purchase by the corporation or other shareholders).
Objectives for a retired or disabled owner include:
- Provide a source of cash for the sale of stock on favorable terms.
- Eliminate conflict of interests between a retired or disabled owner and the remaining owners.
Finally, Mr. Mezzullo addresses objectives for the remaining owners (other than the one whose interest is being purchased):
- Provide certainty for the remaining owners of the pricing and terms of potential future transactions with departing owners.
- Through note arrangements, provide a form of long-term financing for purchases to facilitate the ongoing operations of the business.
- Avoid what Mr. Mezzullo calls the “moral dilemma” of negotiating with a departing owner (or spouse or estate representative) at a time when they might be in a weak bargaining position.
- Assure that the ongoing efforts of the remaining owners inure to themselves and their families, and not to a departed owner.
- Facilitate the departure or withdrawal of owners whose objectives change, and help insure that transitions can occur on friendly, predictable terms.
All of these purposes are consistent with what I have observed in advising hundreds of business owners about buy-sell agreements over more than thirty years. The most important benefits in my mind, however, include protection of the business and its shareholders from the fallout resulting from adverse trigger events, including divorce, death of an owner, termination of an owner, or even the departure of an owner on friendly terms. Buy-sell agreements, by specifying what will happen in future, often adverse, events, minimize the prospects of litigation during periods of shareholder transition.
In my experience, buy-sell agreements are integral corporate documents which are common across all industries and corporate forms. That’s why I wrote the book, Buy-Sell Agreements for Closely Held and Family Business Owners. Discounts are available with a special offer for a limited time.