Business Buyout Agreement: What Is It?
Business Buyout Agreement: The Buyout Agreement is unique to business buyouts, but has similar features as a partnership agreement. It memorializes the process of an existing partner buying out another, such that each partners investment can remain relatively equal. Business buyouts occur for a myriad of reasons: retirement, death, disability, breach, unapproved new partner admission, misconduct, etc . A buyout agreement is the most useful document for dealing with these events. In the absence of a buyout agreement, the existing written partnership agreement would be used, or if none exists, the ABC rules would apply (those rules will be addressed in detail in a future blog). A buyout agreement allows the partners to take control of the buyout process and outcome by setting up the terms under which the buyout will occur.
Why Buyout Agreements Are Important for Businesses
Businesses operate through the combined efforts of people in a court-defined legal entity. Although these people form an agreement to work together, they are all still separate legal entities in their own right. When one of the people no longer wishes to be in the business, for whatever reason, that change can cause a huge disruption to the business unless there is an agreement in place that allows for the uninterrupted transition of the ownership of the business. That agreement is known as a buyout agreement or buy-sell agreement. If a buyout agreement is in place at the time of the person’s decision to leave the business, the interruption is normally very minimal and the parties simply follow the rules laid out in the buyout agreement.
Without a buyout agreement, however, the ability of the other owners to pick up the pieces and move forward is far more challenging. There is no requirement that either the business or the people currently working in the business be treated fairly. The person leaving the business can potentially harm the existing business. Without an agreement defining the situation and requiring fairness, the chances for bad things to happen increase and thus make it necessary for all of the people involved to have a buyout agreement.
Essential Elements of a Buyout Agreement
A buyout agreement is a legally binding contract that outlines the process for the transfer of business ownership in the event of certain pre-determined situations. There are several key components to a comprehensive buyout agreement, including a valuation of each co-owner’s share of the company, the terms and conditions of the transfer of ownership and any other legal considerations with respect to the transfer of ownership.
Determining the value of each co-owner’s interest in a business is typically the first step to drafting and finalizing a buyout agreement. The value is often determined by objectively appraising the company through a third party or by way of a self-assessment for smaller companies. The determination of the value of each co-owner’s interest is a very important component of the buyout agreement and should be carefully considered by all parties involved.
The next important component of a buyout agreement concerns payment. This section of the agreement will outline how and when the purchasing co-owner can acquire the ownership interest. For example, it may provide lump sum payments at the time of purchase or periodic payments over a period of months or years. The timing of the payments can also be addressed. If the buyout transaction is closing as a result of the death of the deceased co-owner, the buying co-owner may be required to pay the estate in full at the time of the closing.
In addition to the economic aspects of the purchase, a buyout agreement may also address the terms of the purchase in different situations, including the transfer of ownership in the event of a co-owner’s disability, the death of a co-owner or the retirement of a co-owner. The agreement may also outline the manner in which a termination of ownership will be triggered if one co-owner becomes involuntarily terminated. In such a situation, the agreement should provide for the purchase of the ownership interest of the co-owner whose employment was terminated within a specified period of time.
An attorney can help all parties in ensuring that the buyout agreement contains the necessary components to protect their respective ownership interest in the business.
Essentials of Buyout Agreement Creation
The ultimate goal of a buyout agreement should be protection: protection of the business itself, the remaining owners, and in the case of disability or death, the persons you want to benefit. Your buyout agreement should cover all of the major contingencies and describe the procedures and valuations used to effectuate the purchase on a buyout event.
Negotiations. Each owner of the business may have their own opinions on the terms that should be included in the buyout agreement. Therefore, the first step is to discuss the terms that each owner will be comfortable with. Then, with the assistance of your attorney, a draft agreement should be created.
Execution. Once each owner has reviewed the draft agreement, discussed it with your accountant and/or other advisors, and they agree with its terms, the agreement should be signed. Everyone should receive copies of the final document for their records.
Funding. Depending on the terms, the buyout agreement may require funding – either by insurance policies on each owner or an already agreed upon lump sum payment. If funding is needed, such funding should be procured and the documentation for such policies or agreements should be attached to the buyout agreement.
Updates. An annual review should be performed of your buyout agreement to determine whether changes are required. Annual reviews will also help to determine if a buyout event has occurred and whether the terms of the buyout agreement have been triggered.
Pitfalls in Business Buyouts
The process of negotiating a buyout agreement can be fraught with obstacles and challenges. That is why it is so important for a business owner to have skilled legal counsel during this phase of the life of a company. Some common challenges and mistakes that can occur are:
• Exposing the business to liability -Sometimes owners do not want to look at the immidiate or long-term liabilities of buying out another owner. They may be too emotionally invested in the transaction to consider the full range of potential risks that come along with buyout. In these situations, the buyout agreement can put the future of the business at risk if certain clauses are not carefully drafted to protect the interests of the buyer or seller. Any liability for breach of contract of the buyout agreement could potentially fall back on both parties.
• Not allowing the process enough time – For many businesses, there may not be a situation where a buyout agreement is needed , yet owners attempt to create one in order to resolve an internal conflict. However, when owners are unhappy with one another and do not have the energy to resolve their differences, they should not rush the process and create an agreement that will not be adequate for their situation. Similarly, an owner should not try to initiate a buyout on a whim, although this is more of an issue for the seller than for the buyer. It is important to give the process enough time and develop an agreement that is truly beneficial to both sides.
• Failing to consider all contingencies – From a business perspective, everything may be going well and an owner may not be concerned with what could happen if a change in the industry causes the business to be worth less, or if a key employee leaves and takes valuable customers with him or her. Without appropriate consideration of contingencies, a buyout agreement may not be sufficient to navigate these possibilities and could set both parties up for failure.
Legal Issues in Creating Buyout Agreements
There are several legal considerations that must be examined when developing a buyout agreement. Some of these considerations are applicable to all buyout agreements, while others will depend on the specific nature of the agreement.
State Laws
One of the most important legal considerations in drafting a buyout agreement is state law. A business may operate in many different states, and in those circumstances, examination of the laws of each state is critical when creating a buyout agreement. Some provisions may be legal in one state but illegal in another. Other provisions may have specific requirements under state law that must be fulfilled.
Agreement Principles
All buyout agreements must be based on sound agreement principles. Courts do not enforce agreements that are vague, ambiguous, unduly confusing, or contradictory. Good drafting practices should always be employed, keeping in mind that the agreement should reasonably notify the parties of their rights and responsibilities. In most cases, a poorly written buyout agreement will be unenforceable in a court of law.
Specific Legal Elements
There are some elements that should always be part of a buyout agreement. One of those is sufficient consideration, or an exchange of value that is germane to the transaction. If the consideration falls short, it can invalidate the buyout agreement. Similarly, parties should be sure to articulate their intentions clearly: if there is any ambiguity present in the provisions surrounding the business’s valuation process, the purpose of the agreement, or other key terms, those ambiguities can lead to litigation in the future.
Parties to a buyout agreement should always be sure to seek the counsel of a qualified attorney before signing the agreement. Legal counsel can also help with the drafting process. There are several important reasons for seeking legal counsel when drafting a buyout agreement, including:
State laws, agreement principles, adequate consideration, articulate intentions, and participation of legal counsel are necessary legal aspects of the buyout agreement.
Buyout Success: Sample Business Agreements
Consider the case of Ashworth Manufacturing, a small family-owned business that has been a market leader in its niche for over three generations. In their buyout agreement, they included terms that addressed concerns over the company’s continued success into the hands of reforming successor who had very different ideas about the future of the company. They initiated a stock buy-back plan that triggered a buyout option on the departure of a key executive in five years, before he could gain majority control but after he had acquired full ownership. This buy-out allowed them to acquire the shares at a set price that did not overvalue the company’s current worth and yet would not undervalue the business based on its future potential, when the key executive would have departed anyway. The company was successfully bought back by the family at the pre-determined price, when the key executive departed the following year .
For Synergy Consulting, a boutique marketing firm specializing in technology startups, the relatively small size of the business didn’t seem like it would make for a significant sell-out, but the compensation package the founding partners negotiated turned out to be one of the most lucrative deals for the team, who ended up able to retire before they turned 40. They had included a sliding scale for stock to be offered after two years from their original purchase date, the price going up at increments of $1 million every five years. After five years in business, their company was sold for almost seven times what it was worth at the two-year mark. They received their fair share of the company’s value without having to wait so much as a moment longer than they’d anticipated, due in no small part to their excellent buyout agreement.