How do Buy-Sell Agreements Work?

By: Jesse Jones

Anyone who has started or is starting a business with a partner should read this article. Why? Because Buy-Sell Agreements allow business partners to agree in advance on how to handle major disagreements and disruptions, so they are really important for any business that is owned by more than one person (click here for a general intro to Buy-Sell Agreements).

When you hear the term “Buy-Sell Agreement” you shouldn’t necessarily think of a stand alone agreement that is actually called a Buy-Sell Agreement, although that could be the case. Rather, the protections provided by a buy-sell are often found inside of other, broader documents. Outside of a stand-alone buy-sell, some of the most common documents you’ll see buy-sell agreements in are (1) a stock repurchase agreement (also called a restricted stock agreement) for a corporation that plans to be venture-backed, (2) a buy-sell section of an operating agreement for a multi-member limited liability company, and (3) a shareholders agreement of an non-venture backed corporation.

Below, we’re going to look at the elements of a common buy-sell provision and then apply two different situations to those elements to see how the buy-sell agreement works.

Generally speaking, a buy-sell agreement consists of the following elements:

1. Triggers and notice requirements (these are the actions that result in the right or obligation to purchase - like death, incapacity, bankruptcy, etc., and the responsibility of the partner involved in that action to notify the other partners about what happened).

2. Rights and/or obligations to purchase (a buy-sell agreement can be set up to require a person to buy out the withdrawing partner or to give a person the right to buy out the withdrawing partner).

3. Identification of the buyer(s) (most commonly the company itself or the remaining partners).

4. Valuation, including discounts if any (a pre-agreement on the purchase price or the method of determining the purchase price at the applicable time - also sometimes buy-sell agreements provide for different valuations/methods depending on the particular trigger).

5. Payment terms (application of insurance proceeds, if applicable, and the timing of payments)

6. Consequences of not exercising available purchase rights (typically the buyer has a specified amount of time to consummate the purchase from the withdrawing member after which the shares may be able to be sold to a third party).

SITUATION #1: a venture backed corporation

In venture-backed companies, the market norm is that founders’ stock will vest over 4 years. If a founder leaves the company before all of his/her shares are vested, the company has the right to buy back the unvested shares. Normally, the re-purchase price is par value, and the company might be deemed to have exercised its re-purchase right if it doesn’t actually do so. How does that stack up against our elements?

1. Triggers and notice requirements - founder leaves company

2. Rights and/or obligations to purchase - company has the right (not obligation) to re-purchase unvested shares

3. Identification of the buyer(s) - company (not other shareholders) has the right to buy

4. Valuation (including discounts if any) - purchase price is par value

5. Payment terms (application of insurance proceeds, if applicable, and the timing of payments) - company writes a check to the founder for the purchase price

6. Consequences of not exercising available purchase rights - company is deemed to have exercised the right even if it doesn’t provide the paperwork and payment in time

SITUATION #2: a multi-member LLC

In our experience, buy-sell provisions included in the operating agreement of a multi-member LLC tend to be much more customized to the specific situation as compared to the protections in a venture backed company. This is partially because the LLC structure is more common when the founders are looking for a long-term business as opposed to one that they plan to start, grow and sell (or take public) on a condensed time frame. While it is impossible to account for every single specific scenario in an operating agreement, the exercise of thinking through what events should trigger buyout rights and obligations and the valuation methods that should be applied is one that business partners would do well to undertake early in their relationship.

With that said, there are certain parts that are relatively standard. Normally things like death, incapacity, insolvency and a material breach of the operating agreement will give the company and/or the other partners the right or the obligation to purchase the withdrawing partner’s ownership. Many agreements distinguish between the death of a partner (which results in the obligation to purchase) and all other buy-sell events (which result in a right to purchase). Most agreements require the withdrawing partner or his/her estate to give notice to the company and the other partners within 10 days after a buy-sell event happens, and most allow the partners to determine the purchase price with a backup plan of having an appraised value determined by a third party. Many agreements allow the company or the remaining owners to make full payment over 5 years and provide that the failure to exercise a right to purchase may result in the withdrawing partner’s ability to sell his/her ownership to another person.

So how does that stack up against our elements?

1. Triggers and notice requirements - death, incapacity (etc.) of a partner

2. Rights and/or obligations to purchase - company has the obligation to purchase on death, right to purchase on other triggers

3. Identification of the buyer(s) - company (or other partners, depending on agreement)

4. Valuation (including discounts if any) - partners agree on value, appraisers determine if there is no agreement

5. Payment terms (application of insurance proceeds, if applicable, and the timing of payments) - company can make full payment within 5 years of closing

6. Consequences of not exercising available purchase rights - withdrawing partner can sell to a 3rd party

Some of the variations that we have helped business owners create and document include (1) a spouse’s put right in the event of death or disability of a business partner (so the surviving spouse of the partner can decide whether to have the company buy), (2) creating a trigger around the transfer of shares from a partner to a specific person (designed to prevent a wayward son or daughter from becoming an owner of the business through the passing of ownership through the original partner’s estate), (3) applying a discount to the purchase price in the event of specific triggers (to avoid a situation where the company or remaining owners have to decide between paying a bad actor full price and allowing a bad actor to remain as a partner), and (4) specific employment related provisions (to protect passive owners against a sweat equity partner failing to perform).There are countless variations that can be made to buy-sell agreements in any type of document where these provisions appear. Needless to say, buy-sell agreements can get complicated, and, as mentioned above, they are very important for business partners to work through at the earliest possible point.

Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.