Buy-sell agreements are a type of contract used in small or medium-
sized companies that have relatively few owners. By default, ownership
of an LLC or a corporation (called “stock”, “shares”, or “membership
interest”) is legally considered to be personal property that each owner
may sell or transfer at his or her sole discretion.
However, owners of
closely-held companies have numerous reasons why they wish to
impose restrictions on their ability - and on each others’ ability - to sell
shares.
Overview of Buy-Sell Contracts
A buy-sell agreement could be formed while the company is initially
formed, or it might be formed after the company has been operating for
many years. The agreement might be its own, free-standing document,
or it might be a clause found within a larger document such as articles
of organization or corporate bylaws. So long as the terms are not
unreasonably oppressive, Arizona courts will enforce buy-sell
agreements.
A buy-sell agreement may contain certain clauses, such as establishing
a mechanism for dealing with disputes that might arise among the
shareholders, or establishing a way to value the business at a price for
which stock will be transferred. Buy-sell agreements often require that
one shareholder's stock must be sold to the other shareholders upon
the occurrence of certain events, such as the death of a shareholder or
the termination of employment of the shareholder. This way, owners of
a closely-held company do not end up with unwanted partners, such as
the family members of their late partner, or a disgruntled former
employee.
Triggering Events
Typical buy-sell provisions describe which events will trigger an owner's
right to purchase another owner's shares, as well which events will
trigger one owner's obligation to sell stock to his or her partners. Buy-
sell agreements can cover a wide range of events which may occur in
the personal and professional lives of each owner. The most common
trigger event is the death of an owner. In such cases, partners may
have a purchase-option period during which they may unilaterally
decide to purchase the shares from the estate of the recently deceased
owner. The surviving partners may wish to do so because they do not
wish to be partners with the widow or the children (the estate) of their
former partner. The members of the estate might not be equipped with
the skills or know-how to successfully manage or work the business.
Sometimes, an aging or retiring partner wishes for his or her family
member to "take over" the business. However, the success of a closely
held business often depends on the ability of a small number of owners
to work well together, and it is not always clear that the owners can deal
in a similar manner with a spouse or children of a current or former
owner. Consequently, buy-sell agreements often restrict owners not
only from selling shares to a third-party purchaser, but also restrict
owners from giving away their shares as a gift to family members.
Some buy-sell contracts come into play if a partner should unexpectedly
become disabled. When the continued active involvement of every
partner is vital to the success of a business, the disability of a
shareholder is a triggering event under the buy-sell agreement. The
company could even purchase a disability-insurance policy to fund this
type of buyout.
The type and scope of triggering events used in a particular situation
depends on a variety of factors, including the size of the enterprise, the
nature and scope of its activities, the number of owners, the extent to
which the owners participate in the business, the health of the owners,
the financial conditions and family situations of the owners, and the
individual preferences of the parties.
Right of First Refusal
A "right of first refusal", sometimes called a "cross-purchase
agreement", is a type of buy-sell agreement. It is entered into among
the owners of a small or medium-sized company, and typically provides
each partner with either the option or the obligation to purchase the
shares of the other partners upon the occurrence of certain specified
events. For example, if a partner wishes to sell his or her shares, a right-
of-first-refusal agreement may require that this person must first offer to
sell those shares to his or her partners rather than selling to a third
party. The right-of-first-refusal might spell out the price of the shares,
and might include a mechanism for appraising those shares.
Alternatively, the right-of-first-refusal might simply say that current
partners receive a 30-day option period during which, if they match the
proposed price being offered by a third party, then they have the right
to purchase those shares.
General Considerations for Buy-Sell Agreements
Buy-sell agreements can be among owners of a limited liability company
("LLC"), or among owners of a corporation. When the corporation is an
S-corp, meaning it has a small number of owners who choose each year
to opt for pass-through taxation rather than double-taxation, the buy-
sell agreement should be sure to provide that partners are barred from
selling their shares to a purchaser who would render the company
ineligible to continue receiving S-corp status. This type of provisions
would make it clear that any transfer to a person or business entity that
would endanger the corporation's S election will be null and void, even if
the other transfer procedures in the agreement had been followed.
When these scenarios come into play, the various business partners
often wonder how to distribute the purchase-option rights. For example,
a business might have ten different owners, each of whom own varied
percentages of the business - one person might own 50%, while
another owns 20%, while others own only 5%. In such cases, the
common solution is that the purchase-option rights are distributed pro
rata among all of them in proportion to their amount of ownership.
However, it is possible to establish other methods and priorities for this
type of ownership group, such as giving the minority owners the first
right, or giving the majority owner the first right to purchase the
departing partner's shares. Also, it is common to allow those
shareholders who do purchase their proportionate share of the selling
shareholder's stock to purchase any portion of the offered shares which
are not purchased by the other shareholders.
Note that Arizona is a community-property state. Therefore, a partner's
spouse may have a community property interest in the shares which are
subject to the buy-sell agreement, and could assert an ownership right
during a divorce proceeding. Therefore, buy-sell agreements often
require that the spouse of each married partner sign a waiver agreeing
that the spouse's community interest in the shares are subject to the
buy-sell agreement and are subject to sale on the triggering events.
Determining a Price
One way to determine the value to be paid for a departing partner's
shares of a business is called the "Russian roulette" procedure. This
comes into play in the event of an impasse, when partners cannot come
to an agreement regarding how much the shares are worth. This
procedure mandates that when Partner-A offers to sell his or her shares
to Partner-B for a certain price, Partner-A is simultaneously offering to
purchase the Partner-B's shares for that same price. This ensures that
Partner-A does not offer a "low ball" or unreasonable price. This
procedure requires Partner-B to either accept the offer and buy the
shares at the offered price, or sell his or her shares to Partner-A at that
same price.
In many cases, owners of a small business lack the cash to buy out their
partners, especially if they have been reinvesting the profits from the
business back into the company. In such cases, the partners may wish
to take out mirroring life-insurance policies. In that event, if Partner-A
passes away and Partner-B wishes to purchase Partner-A's ownership
interest from Partner-A's estate, then Partner-B could use the life
insurance proceeds for that purpose. Another option is for the
purchasing partner to make installment payments to the selling partner.
This usually involves an amount of cash down, and then an interest rate
on the amount that is carried in installments.
Conclusion
When drafting a buy-sell agreement, Arizona business attorneys take
many factors into account, including the type of business, the
involvement of each owner, the age of its owners, the short-term and
long-term goals of the owners. The lawyer can always amend the buy-
sell contract provisions over time, as the company matures and its
owners’ circumstances change.
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