Buy-Sell Agreements: Why Every Business Needs One

A buy-sell agreement is a necessity for any co-owned startup business. Most entrepreneurs don’t spend a lot of time thinking about their eventual departure from their recently formed startup, but a set of rules detailing the terms and procedures of the inevitable parting can obviate countless headaches in the future.

 

What is a Buy-Sell Agreement?

Buy-sell agreements define and govern the rules of transferring corporate stock[1] in the event a shareholder decides to transfer, gift, or otherwise relinquish her shares. The agreement generally defines and controls 1) who is eligible to purchase the shares, 2) which events trigger a right to purchase the shares, and 3) the terms and conditions of the purchase.

Buy-sell agreements can include a wide array of common provisions depending on what the company and shareholders are trying to accomplish. These agreements typically answer questions such as: Is a shareholder’s family entitled to her shares upon the shareholder’s death? Does the family acquire all the rights of the deceased shareholder? Can a company repurchase the stock of a shareholder who was recently convicted of a serious felony against the shareholder’s wishes? How is the purchase price decided? Are there limits on when or to whom shareholders can sell their stock? The purpose of a buy-sell agreement is to provide answers to these questions, and many more. Having a clear set of stated rules can prevent a wide array of different kinds of disputes between co-owners in the event of a potential sale.

 

Common Provisions

Right of First Refusal – A right of first refusal is a popular provision in buy-sell agreements and requires a selling shareholder to offer her stock to either the corporation or remaining shareholders before she sells to a third-party. The terms of the sale to the corporation or shareholders often must match or exceed the established arrangement with the third-party.

Example – Sara wants to sell her shares and finds a buyer in Billy, a third-party, who agrees to buy all her shares for a total of $1,000. A right of first refusal gives the company and/or remaining shareholders the right to purchase Sara’s shares in lieu of Billy, but only at a price of $1,000 or greater. Sara is allowed to sell her shares to Billy only if the corporation and the shareholders do not exercise their right to purchase her shares.

Analysis – A right of first refusal allows the company to “keep it in the family.” It obviates the risk an outsider might bring to the company. Many closely held companies implement rights of first refusal to prevent unwanted third-parties from becoming a shareholder.

This right also assures the seller a fair price for her stock. If the company does not want a third-party to become a shareholder, it must match the price offered to the seller, effectively the fair market value.

 

Right of First Offer – A right of first offer acts in a manner similar to a right of first refusal, but instead allows the seller to offer her shares to the corporation BEFORE finalizing terms with an outside party.

Example – Sally decides to sell her shares and offers to sell them to the company for a total of $1,000. If the corporation declines her offer, Sally is then free to sell her shares to any third-party for a price greater than or equal to $1,000.

Analysis – A right of first offer, as opposed to a right of first refusal, is more advantageous to the seller. Rights of first refusal tend to dampen the value of a seller’s stock because potential buyers understand their offer will likely be negated when the company decides to purchase the seller’s shares. As a result, many potential buyers refuse to put forth the due diligence required in researching the purchase. Potential buyers in a right of first offer, on the other hand, know they will not face the same barrier and are more willing to invest the time and effort required before such a purchase. Consequently, sellers attract more interest when they are restricted only with a right of first offer, as opposed to a right of first refusal.

 

Option – An option to repurchase gives the company and/or other shareholders the right to repurchase the stock from another shareholder upon certain triggering events. The declaration of bankruptcy, filing for divorce, conviction of a felony, and termination of an employee-shareholder are all examples of events that might trigger an option to repurchase the stock of the respective shareholder. Because options, unlike rights of first refusal or rights of first offer, do not inherently include an offering price, the buy-sell agreement should establish a method of valuation for the stock.

Example – Fred was convicted of murder and sentenced to twenty years in prison. Such a felony was listed as a triggering event in the buy-sell agreement. The company now has the option to repurchase Fred’s 100 shares, regardless of any possible objections from him. The buy-sell agreement specifies that, in the event of an option to repurchase, the company will pay the selling shareholder $50 per share. If the corporation decides to exercise its option, it must pay Fred $5,000 for his 100 shares.

Analysis – Options give the corporation a way to mitigate potential harm caused by certain “triggering events.” Fred is unlikely to add value (and can potentially contribute a significant amount of harm) to the company from prison during the next twenty years. The option gives the company a way to divest from Fred and put his shares to better use elsewhere.

 

Drag-Along – A drag-along gives a company the right to require its shareholders to participate in the sale of the company.

Example – Matt is the majority shareholder (80%) of a company and would like to sell his shares. Abe wants to purchase the company, but he is only interested in purchasing the entire company. He is not interested in acquiring only 80%. Mitchell, the minority shareholder (20%), has no desire to sell his shares. The drag-along provision forces Mitchell to sell his shares to Abe along with Matt.

Analysis – Drag-along provisions prevent holdouts. Companies often have many shareholders, and not every shareholder is always eager to sell. Without a drag-along, a single shareholder could potentially block the sale of a company initiated by a majority of the other shareholders.

Drag-alongs also benefit minority shareholders. With a drag-along provision in place, otherwise powerless minority shareholders do not have to worry about other “holdout” shareholders blocking a valuable transaction.

 

Tag-Along – A tag-along gives shareholders the right to include their stock in the sale of another shareholder’s stock. The shareholder exercising his tag-along right is often entitled to the same terms and conditions agreed to between the initial seller and third-party.

Example – Samantha, who currently owns 80% of a company, wants to sell all her shares to Iris for $100/share. Tiffany, who currently owns 20% of the company, does not want to be involved in the company without Samantha. Tiffany can exercise her tag-along right and force Samantha and Iris to include her shares in their transaction with the same terms and conditions. Because Tiffany’s shares are now tagging-along with Samantha’s shares in the transaction, Iris can no longer only purchase Samantha’s 80%. She must either purchase both Samantha’s and Tiffany’s shares, which would give her 100% of the company, or purchase nothing. If she decides to proceed with the purchase, she must also pay Tiffany $100/share.

Analysis – Tag-alongs are often in the best interest of minority shareholders. If a majority shareholder decides to sell his shares, it is often because he received a favorable price. A tag-along prevents the minority shareholder from getting stuck with the third-party purchaser. Instead, she can exercise her tag-along right and sell her shares at the same favorable price received by the majority shareholder.

 

Rights of first refusal, rights of first offer, options, drag-alongs, and tag-alongs are just a few of the common provisions found in buy-sell agreements, yet each wields tremendous sway in determining whom a corporation’s shareholders will be and how much power and interest those shareholders will have. Every entrepreneur should take great care in structuring a buy-sell agreement. The time and effort that goes into it may not seem worthwhile at the time, but it could prove priceless down the road.

[1] This article refers to shareholders and stock within the corporate structure, but the same principles apply to any co-owned company (e.g., members and units within an LLC as well as partners and interest within a partnership).