Buy-Sell Agreements

            The provisions for restrictions on transfer of interests in limited liability companies, in partnerships and in corporations, and for buy-sell requirements and terms, are often set forth in an entity document, such as the LLC Company Agreement, Partnership Agreement or Corporate Bylaws. They may be set forth in a separate agreement, and often are when funded by life insurance. A person (individual or entity) who owns an interest in the business is called an "equityholder." The stock, partner or member interest is referred to as the equity.

A.        Purpose
           A buy/sell arrangement is generally recommended for most closely held businesses. Without such an agreement the departing or deceased owner or her survivors will usually be unable to obtain a fair value for the owner’s interest, and the possibilities of disruption of the business and hostility among the owners and other interested parties are increased. A carefully structured buy/sell agreement can meet the specific objectives of the seller/buyer in these situations, promoting an orderly and economical transition of ownership while maintaining, to the extent possible, the value of the business.

B.        Business Dynamics
           Because buy/sell agreements are most often used by the owners of closely held businesses, there is a need to consider carefully the special dynamics of these businesses.
1.         “People” Factors
           In planning a buy/sell agreement, careful consideration must be given to the “people” issues. Often, this will require an understanding of family relationships, who are active and non-active participants in the business, the philosophy of the “controlling owner” (e.g., parent or surviving parent), spousal relationships, key persons, and other people-oriented factors.

2.         Economic Factors
           Although difficult to do, it is essential to assure that the business owners fully understand the economic consequences of their agreements -- to the business, its continuing owners, and the family or survivors of the selling shareholder. For this reason, it is generally advisable to involve other professionals such as accountants, appraisers, and insurance professionals to assist in the understanding and planning of the economic aspects of the agreement.

3.         Tax Factors
           A buy-sell arrangement must also be analyzed carefully to determine the likely income, gift, estate and generation-skipping tax consequences, including under Chapter 14 of the Internal Revenue Code (“Code”).

C.        Forms of Agreement
1.         Alternatives
           Buy/sell agreements generally follow three different formats: (i) equity redemption, in which the business agrees to purchase the equity of a deceased or selling equityholder upon certain events; (ii) cross purchase, in which the continuing equityholders individually agree to purchase the equity of a deceased or selling equityholder upon certain events; or (iii) a hybrid (usually a combination of the foregoing two types of agreements).

2.         Hybrid Agreement
           A hybrid buy/sell agreement generally employs a partial equity redemption and a partial cross purchase agreement to satisfy certain specific objectives or to avoid potential problems. For example, such an agreement is often used where (i) a business cannot buy all the shares of a selling equityholder due to limits on its available capital or because of creditor-imposed limitations, or (ii) a redemption cannot be made without dividend consequences under Section 302 of the Code due to continuing family ownership and attribution, but a partial redemption can be made pursuant to Section 303 of the Code, or (iii) insurance funding will be used for certain buy-sell events (e.g., death) and will be “cross-owned” by the equityholders, with the business being the primary buyer for other events of purchase (e.g., termination of employment).

3.         Selection
           Each fact situation must be reviewed separately with proper weight being given to all relevant factors, including the factors described in the preceding paragraphs as well as other tax considerations, before a determination can be made as to the best form of agreement.

D.        Drafting The Buy/Sell Agreement
1.         Overview
           The considerations are applicable in most cases to cross-purchase and hybrid agreements whether in a corporation, limited liability company or partnership context.

2.         Parties
a.         Members/Partners
           As a general rule all equityholders should be parties to the buy/sell agreement. For minority equityholders, however, consider a separate agreement between that equityholder and the business without subjecting the majority equityholder’s equity to the terms of the agreement. In addition, in many family business succession plans, the children or other lower generation owners of the equity  are often parties to a separate buy-sell agreement (in addition to the primary buy- sell applying to senior generation family owners). This separate buy-sell agreement controls events such as death or termination of employment by a child and permits transfers between the children to address these events, rather than having value repurchased by the senior generation (or the business) which would inure in part to the benefit of the senior generation.

b.         Equityholder’s Spouse
           If an equityholder’s interest is owned as community property (which most often the case), the spouse of the record owner should be included as a signatory to the agreement or on a written consent agreeing to bind his community interest. Caution:  If an equityholder’s spouse is an actual named party to the agreement, special care must be undertaken in drafting the agreement since the agreement may require all parties (including the spouse) to agree on certain matters, such as amendment, termination, or revaluation of shares.

3.         Delineation of Purposes
           It is desirable to set forth the business purposes for which the agreement has been entered into, such as continuing the business, limiting ownership of the business, providing an orderly manner of transferring the equity, providing a market for the equity in the event of death, disability, termination of employment, bankruptcy or other events requiring purchase, securing continuity in the management of the business, and precluding dissension and conflict among the equityholders and their families upon equity disposition.
            Setting forth the purposes of the agreement can support the proposition that the agreement is not a device to effect a testamentary transfer at a price per share less than its fair market value, in which event the agreement will be disregarded in establishing the value of the equity at time of death. To avoid the agreement being so construed, it is advisable not to include a reference to tax motivation as a purpose of the agreement. In cases such as the family business context, careful attention should be given to stating the business purposes.

4.        Permitted Transfers
           The agreement may permit a transfer of equity to family members or to a trust or other entity (such as an FLP) for their primary benefit. If such transfers are permitted, the transferee should be required to join in the agreement before receiving transfer if the equity. The agreement should specify whether the equity will continue to be subject to the terms of the agreement as if owned by the transferor equityholder, or if the transferee becomes a party to the buy/sell agreement in his own right. If the transfer is to a trust or other entity, consideration must be given to certain events causing purchase, such as death.

5.        Optional vs. Mandatory Purchase
           If the primary goal of the buy/sell arrangement is to provide a market for a selling an equityholder’s (or his estate’s) equity interests, consider providing for a mandatory purchase of the equity by the entity, or the other equityholders, upon events such as death, disability, and possibly retirement. At the same time, however, the ability of the purchaser to fund the purchase of the departing equityholder’s shares will need to be considered. In this situation, consider requiring the departing equityholder (or his estate) to offer to sell his shares to the business or the other shareholders, but provide the purchasers with the option, rather than the obligation, to purchase the shares. Such a provision may also be appropriate upon other events of purchase (such as the bankruptcy or insolvency of a shareholder or termination of a marital relationship), particularly if the purchasers may have difficulties obtaining sufficient funds for the buy-out.

This memorandum contains general information and while the information presented is accurate as of the date of its publication, it cannot be relied upon as legal advice, as that can only be obtained through personal consultation with an attorney with whom you share your specific facts.

 Copyright © 2007 by Sterling A. Minor. All Rights Reserved.

Last Updated: July 25, 2007