Buy Sell Agreements: Protecting Business Ownership and Succession

In a cross-purchase agreement, each owner agrees to purchase a proportionate share of the departing owner's interest directly, and each purchasing owner takes a cost basis equal to the price paid, which reduces capital gains exposure on any future sale, and corporate governance counsel advising on buy sell agreements structure should confirm whether a cross-purchase or entity redemption structure is more appropriate based on the number of owners and the age disparity among owners that affects life insurance premium costs.

The triggering events clause defines the circumstances under which the buy sell agreement's purchase and sale obligations become mandatory, and a well-drafted provision covers not only death, disability, and retirement but also voluntary withdrawal, bankruptcy, divorce, loss of professional licensure, and deadlock among owners, and business succession planning counsel drafting buy sell agreements should determine whether the triggering events clause addresses the specific ownership and governance risks of the business and whether the disability definition requires an independent medical determination or allows remaining owners to make that finding.

When an owner dies without a buy sell agreement in place, the deceased owner's interest passes to heirs who may have no understanding of the business, no relationship with the remaining owners, and no obligation to sell on terms the remaining owners can afford, and business dispute litigation counsel handling ownership disputes arising from the absence of buy sell agreements needs to assess whether the surviving owners have any legal mechanism to compel the estate to sell the interest and whether emergency injunctive relief is available to prevent the estate from transferring the interest to a third party while the dispute is being resolved.

A co-owner's death, disability, or involuntary departure can create an immediate liquidity crisis for the remaining owners, who may lack the cash or borrowing capacity to fund a buyout at fair market value and who may face a forced sale of the entire business if no buyout mechanism exists, and business litigation counsel advising owners confronting a buyout obligation without adequate buy sell agreements or funding is responsible for examining whether any right of first refusal in the company's operating agreement provides a contractual basis to delay or structure the buyout and whether a court-supervised appraisal process is available to establish a price that the parties can use as the basis for an installment payment arrangement.

Buy sell agreements typically use one of three valuation approaches: a fixed price that owners agree to review and update periodically, a formula based on a multiple of earnings, book value, or revenue, or an independent appraisal process in which qualified business valuators determine fair market value at the time of the triggering event, and mergers by acquisition and business valuation counsel advising on buy sell agreements valuation methodology should assess whether the chosen method produces a fair result across multiple scenarios, including normal operations, rapid growth, and financial distress.

The most common funding mechanism for buy sell agreements is life insurance, which provides immediate liquidity at the moment of the triggering event that is most difficult to fund from operating cash flow, and estate planning and business succession counsel advising on buy sell agreements funding needs to verify whether the insurance coverage amount is sufficient to fund the buyout at the current valuation and whether the policy ownership structure aligns with the cross-purchase or redemption structure chosen for the agreement.

The transfer restriction provisions of buy sell agreements must clearly prohibit each owner from transferring any portion of the business interest to any third party without first offering the interest to the remaining owners and the entity at the agreement's established price, and contract drafting counsel designing buy sell agreements for closely held businesses should examine whether the right of first refusal is structured as a right to match a bona fide third-party offer or as a put right at the formula or appraisal price and whether the transfer restriction is broad enough to capture indirect transfers through trusts, family limited partnerships, and holding companies.

Buy sell agreements that are not reviewed and updated regularly become liabilities rather than protections, because fixed prices become stale, insurance coverage amounts fall below current valuations, triggering event definitions fail to address governance changes, and funding mechanisms become misaligned with the entity's current tax structure, and business transfer and succession planning counsel conducting a buy sell agreements review should confirm whether the current valuation method still produces a fair result given the business's growth since the agreement was last updated and whether the life insurance coverage amounts have kept pace with the business's increased value.