The fundamental issue is this: When a shareholder of a closely-held business quits, is fired, dies, or experiences certain life events, such as divorce or bankruptcy, the business may prefer that the shareholder’s equity not remain with her but instead be transferred back to the other owners or the business itself. However, this will NOT happen in the absence of a prior agreement. In the absence of an agreement, if an employee, who owns shares of a company, quits or is fired (even for misconduct or worse), the employee keeps her ownership interest. If she dies, that interest goes to her beneficiaries (e.g., spouse or child) or is distributed by the laws of intestacy where there is no will. If she is divorced or declared bankrupt, then possibly either her spouse or a creditor will be entitled to those shares. As a result, a complete stranger will may own part of your company, which can pose problems on many levels. The solution is a buy-sell agreement.
A buy-sell agreement sets out terms for the remaining owners or the company itself to purchase the departing owner’s stake to preserve the ownership of the company and continuity of operations. A buy-sell agreement can appear as a standalone document but more often is included in a shareholders’ agreement (in the case of a corporation) or an operating agreement (in the case of a LLC).
There is no requirement under New York law to enter into a buy-sell agreement. Yet neglecting to prepare one may mean that the original owners need to deal with either a departed shareholder/employee who is no longer engaged in the business or, in some cases, an indifferent or hostile stranger who was never intended to be an owner in the first place.
Triggering Events—When the Company Has the Right to Repurchase Shares
Below is a list of the most common events triggering the right of the company, or its owners, to purchase the shares held by a departing shareholder.
- Termination of Employment
- Quits. If an employee who also own shares quits, the company may want to buy back her shares. Alternatively, if the employee has worked enough time, it may believe that the employee has earned the right to keep those interests and benefit from a possible future sale of the company. These type of compensation decisions are specific to each company.
- Fired. If an employee is fired, many companies take the position that they are entitled to repurchase any ownership interests. Furthermore, if the employee is fired for cause (say, misconduct at work, fraud, etc.) the agreement could specify a lower purchase price than if the employee is simply let go under normal circumstances.
New York law requires the equitable division of all marital property between the spouses upon a divorce. Business interests are often a major asset for a married couple, and in many cases, absent a premarital agreement stating otherwise, are considered marital property. To avoid an owner’s ex-spouse suddenly having a stake—and a say—in the company, a buy-sell agreement can require an ex-spouse to sell any acquired interest back to the co-owners or the company.
For some types of small businesses, if one owner has to file personal bankruptcy, a bankruptcy trustee can seize that owner’s business interests and use them to repay debts, or even try to liquidate the entire business to take the owner’s share. A buy-sell agreement can limit this risk by requiring the employee to sell her shares to the company or its owners in the event the employee becomes insolvent or files for bankruptcy. In this fashion, the ownership interests will be kept away from the creditors.
- Death or Incapacity
If an owner dies, co-owners do not want to risk the owner leaving their stake to loved ones as part of their estate or having their ownership interests passed on according to New York intestacy laws. A buy-sell agreement can include terms requiring the sale of the deceased owner’s interest to the company or co-owners.
The disability or incapacitation of an owner can hurt a business in many ways. First, if the owner was integral to the management of the business, a sudden absence can disrupt operations. A buy-sell agreement can include specific provisions aimed at preserving the continuity of the business despite management changes. In addition, a power of attorney or family member may try to step in and take over business decisions for the incapacitated owner—despite no previous involvement in the business. A buy-sell agreement can ensure that ownership and management stay with the remaining co-owners. A provision for a buy-out upon incapacity may also be to the benefit of the incapacitated owner, since the purchase will represent a source of funds where the owner is no longer able work.
Funding the Buyout
An owner departure or crisis can take place suddenly, and the business and remaining owners may not have the funds immediately available to purchase the stake. For this reason, a buy-sell agreement should address how to fund the buyout. There are different options, each with its own potential benefits and drawbacks.
- Installment plan – Instead of a 100 percent lump sum payment, a buy-sell agreement can require a down payment and an installment plan for the rest of the buyout price during the next few years. However, the departed owner risks not receiving full compensation if the company fails before the installment plan concludes.
- Sinking fund – This is a savings plan of the business itself that involves putting aside cash earned by the business to create a buyout fund. However, nothing stops owners from using this cash to fund other operational expenses, so it is not guaranteed to be available when a buyout arises.
- Insurance – The business can take out insurance policies on its owners in the event of death or other specified events and the proceeds from the policy can fund the buyout. Owners can also purchase insurance on one another—called a cross-purchase buy-sell—and in this situation, the buy-sell agreement would simply be between the owners. The business entity itself would not be party to the agreement.
Another key term of a buy-sell agreement is to establish a procedure for determining the purchase price to be paid for the departing owner’s shares or interests.
- EBITDA-based Formula. One common method is set forth a formula based on prior earnings, such as a multiple of EBITDA. This has the advantage of removing uncertainty, but can lead to contention if it is felt that the formula does not take into account the real value of the enterprise at the time of the repurchase.
- Third-Party Valuation. Another method is to rely on a third-party valuation. This has the advantage that the valuation will (presumably) be unbiased and take into account nuances that could be ignored by a formula method. Of course, an appraisal is not free.
Preparing a buy-sell agreement is an important, but complicated step for any closely held business. You should carefully discuss your options with an experienced New York City business attorney who can skillfully draft your agreement. Call Braverman Law PC at (212) 206-8166 or contact us online today.