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Don't Buy or Sell Without a Buy/Sell

Many owners and managers have heard of so-called "buy/sell" agreements-but their importance cannot be understated and their need is ever-growing.

Buy/sell arrangements come in many forms-as separate Buy-Sell Agreements, or as provisions in a company's Shareholders' Agreement or a limited liability company's Operating Agreement. In addition, there are various other situations in which buy/sell provisions may be appropriate.

Generally speaking, the purpose of buy/sell provisions is to provide owners, whether they are shareholders of a corporation, members of a limited liability company or owners of some other type of business entity, the knowledge and comfort that there is an agreed upon process to buy out the ownership interests of a withdrawing owner.

Any time that a corporation or LLC (or other type of business entity) has more than one shareholder or member, buy/sell provisions should be negotiated and agreed upon. For the sole owner, the business is intimately tied to him or her. However, with more than one owner, natural life events occur, including death, disability, a divorce action involving an owner (in which the ownership interest is a marital asset), or in the event that there is a falling out of owners, when one either seeks to, or is being sought to, withdraw from the company.

All to often, the time demands on owners and managers when first setting up their company, as well as the similar demands on financial resources, results in the buy/sell provisions and other related shareholder or member agreements getting postponed, sometimes indefinitely. This is, of course, the worst situation. In these cases, inevitably, the need for such arrangements does not become apparent until there is a problem-at which time it is almost impossible, or certainly more difficult, to work out amicable arrangements.

I recommend to all of my new clients, or existing clients that are setting up new business operations, that they immediately enter into the appropriate shareholder or member arrangements, including buy/sell provisions, while it is still easy to come to a mutually agreeable position and at a relatively insignificant legal cost. When a buy/sell event then occurs, everyone has knowledge of the buy-out process and under what terms it occurs.

Recently, I have had occasion with several clients to set up new limited liability companies, or S corporations, where the sole members or shareholders were a married couple. The question has always arisen as to whether buy/sell provisions are necessary. The answer is, in a word, "absolutely." While certain of the typical buy/sell events may also dovetail with provisions provided for in a married couple's estate planning, many other buy/sell events do not.

For instance, it is not uncommon, given current divorce rates, for a married couple to find themselves in a divorce with one of the most significant assets in their marital estate being the company they jointly own. Foresight as to this potential problem-even when the marriage and the business are going along swimmingly well-will provide for good, mutually agreeable buy-out provisions.

The buy-out provisions may provide that one of the two spouses will buy out the other on particular terms. Or, it may provide for various other alternatives, sometimes even selling the business in its entirety. In any case, and regardless of what is considered to be the most acceptable approach by the particular owners, the key is having an understanding up front of the goals, the process and the terms under which the buy-out will occur.

Of course, the key to any buy/sell provision or agreement is how to determine the value of the ownership interest being purchased and, consequently, the terms upon which that payment will be made to the withdrawing owner. How to value a business can be tricky, however.

Sometimes, the owners provide that the company will be valued on an annual basis (by various means) and reflected as an attachment to the actual agreement. While this is a relatively simple, and relatively common, approach and one that seems fair and reasonable, in my experience it is typically unworkable. First, simply due to time demands and other more immediate problems on the minds of owners and managers, such valuation schedules rarely, in fact, are considered and updated on a regular basis. Secondly, determining the value of the company, even on an annual basis, is a difficult and sometimes impossible for owners.

Values, as everyone well knows, vary depending upon the assumptions you are making and, quite honestly, the purpose for which you are making the valuation. Therefore, what might be an appropriate value for a company for insurance purposes may not be an appropriate value for the overall sale of the company, which, in turn, may not be the appropriate value for buying out a minority shareholder or member. So, what seems like a simple, fair and appropriate approach is generally not practical.

Another common approach is to provide for an appraisal of the company at the time of a buy/sell event. An obvious down side is the cost of getting an appraisal, or business valuation, of the company or the ownership interest being sold. However, it is also a more appropriate means for ensuring that there will be an independent third party to determine the valuation.

Likewise, it may very well be appropriate, much like for certain estate planning purposes, to discount a minority interest and such a valuation can be handled best by qualified independent appraisers at the time of the buy/sell event. Typically, by the way, one appraiser is chosen jointly by the purchasers and sellers to determine the value or, in the event they cannot agree on an appraiser, each chooses an appraiser, and sometimes those two appraisers choose a third, to develop an agreed upon valuation.

As you might imagine, there are many intricacies that can crop up in buy/sell provisions. Typically, most provisions are relatively straightforward since the issues are very similar for a majority of shareholders or members. It is important to identify the particular nuances appropriate to your and your company's situation to best provide for such an important event.

Even if everything goes very well for the company and all of its members and shareholders, eventually someone will pass away, for instance, and the remaining owner does not want to have his former colleague's Aunt Betty as his new co-owner! The time, effort and expense involved in preparing a buy/sell agreement, or buy/sell provisions in an existing shareholder or operating arrangement, is well worth the time and effort.

Rich Drake is a Member of Womble Carlyle Sandridge & Rice, PLLC, practicing in the Corporate and Securities Group in Winton-Salem. Mr. Drake advises clients on practical approaches to achieve desired business outcomes in a variety of corporate, securities, financing and business technology matters.

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