What Does a Buy-Sell Agreement Mean for Small Businesses
September 28, 2023Buy-sell agreements are incredibly important for small businesses with multiple owners to have in place. The main purpose of a buy-sell agreement is to provide a method for the orderly transfer of ownership and management control when specific events occur, such as the death, disability, retirement, or voluntary departure of a co-owner. It helps mitigate potential conflicts and promotes a smooth transition.
Provisions that should generally be included in a buy-sell agreement include:
- Triggering events: What triggers a buyout? Death, disability, retirement, resignation, bankruptcy, divorce, or a specific timeframe?
- Valuation method: How will the price of membership interests or shares be determined? A formula? A business valuation expert? And if an expert, who gets to select the expert?
- Restrictions on transfers: Restricting transfers may be important, for example, so that control can remain in the hands of those who founded the business.
- Dispute resolution: It may make sense to provide for alternative dispute resolution if there is ultimately a dispute about the buy-sell agreement, including mediation and/or arbitration in lieu of jumping right to traditional litigation.
Nuances of Buy-Sell Agreement for LLCs, Corporations and Franchises
For many companies – those that are formed as limited liability companies (LLCs) – the buy-sell agreement may be incorporated into the company’s operating agreement. For other companies, such as corporations, the buy-sell agreement is most often a stand-alone agreement separate from the by-laws.
While buy-sell agreements are important for any small business, there are special considerations in the context of owning an interest in a franchised business. In most cases, a franchise agreement will contain its own transfer restrictions and limitations, such as transfer fees, franchisor approval, or giving the franchisor a right of first refusal. If your company operates within a franchise system, it is important to account for the terms of the franchise agreement when drafting a buy-sell agreement or adding buy-sell provisions to an operating agreement.
Aside from transfer restrictions in a franchise agreement, a franchise agreement is usually limited in terms of how long it can exist (e.g., there may be only one option to renew at the end of the first term), and this fact should be accounted for, as well.
There are also tag-along and drag-along rights to consider. These provisions can allow an owner or group of owners to force other owners to sell (drag-along), or they can allow for owners to join in on the sale of ownership interests by other owners (tag-along). These sort of drag-along and tag-along rights can provide important protections for business founders, majority owners, and minority owners and while not every business includes them, they should be considered when drafting company documents.
Failure to Account for Buy-Sell Provisions or Buy-Sell Agreement
Failing to include a buy-sell agreement or to account for buy-sell provisions in an operating agreement can result in disputes down the road. If, for example, an owner dies, there is often a question as to what happens with their ownership interest. Does the surviving spouse get the ownership interest? Or do other owners or the company have to purchase the ownership interest from the surviving spouse so that the surviving spouse is appropriately compensated?
Similarly, divorce proceedings can complicate ownership issues and buy-sell agreements/provisions can help mitigate the uncertainty associated therewith. For example, if an owner gets divorced and that owner’s interest (or a portion thereof) is transferred to that owner’s divorcing spouse, does that divorcing spouse get to remain an owner? Can the divorcing spouse force the company to purchase that ownership interest?
These provisions can also address concerns about voting rights and company control. In some cases, for example, upon a triggering event under a buy-sell agreement, the owner’s ownership interest converts to only a financial interest and any voting rights associated therewith disappear (but can be reinstated by the company’s board).
There is an old adage about not going into business with family or friends. Some – although not all – of the concerns arising from doing business with family or friends can be addressed in a buy-sell agreement. This can help to preserve the personal relationship, as when a buy-sell agreement is absent, the parties might be forced to engage in costly, frustrating, and emotionally draining litigation. This is not to say that a buy-sell agreement solves all possible situations involving transfers of ownership, but it certainly can mitigate the risk of lengthy and expensive disputes.
Legal Expertise and Provisions for Your Small Business Buy-Sell Agreement
If you are forming a small business, speak with experienced counsel about buy-sell agreements/provisions. Garner, Ginsburg & Johnsen, P.A. have a wealth of experience helping LLCs, corporations and franchisees meet their business goals. From forming an LLC to assistance buying a franchise, contact us to schedule a consultation.