Closely Held Businesses: Buy-Sell Basics
Two partners set out on their own to create a business from scratch, intending to embark on an adventure and fulfill the American dream. Making a little money wouldn’t hurt either.
In the midst of start-up efforts, planning for a split-up or even a management deadlock is rarely at the top of the entrepreneur’s to-do list. However, the longer it takes to address succession issues, the more difficult it may be to reach a mutually acceptable arrangement. It is therefore important for every closely held business owner to devise an “exit strategy” tailored to his or her needs. For ease of reference, the examples here assume a two-owner 50/50 voting structure.
There are several ways to plan for the future in the context of a closely held business, and this article addresses just one option: a Buy-Sell Agreement (or a Cross Purchase Agreement), which is intended to address instances when a closely held business owner is concerned about a possible change in the business’ ownership or wishes to force such a change. This article addresses three significant issues:
(1) The death or disability of an owner;
(2) An owner’s lifetime desire to transfer shares to an unaffiliated third party; and
(3) An owner’s lifetime desire to either buy out another owner or to have another owner buy him out.
Death or Disability of a Shareholder
A succession plan for a closely held business should address the process for the transfer of ownership interests upon the death or disability of an owner.
Upon the death or disability of an owner, the remaining owner would be required to purchase the ownership interest of the deceased or disabled owner at a value to be determined. To help fund each owner’s obligation to purchase the ownership interest of a deceased or disabled owner, each owner could be required to purchase life insurance on the other owner’s life. The purchase price for the ownership interest of the deceased or disabled owner could be determined by any number of methods including an appraisal, a formula, or the proceeds of life insurance on the deceased owner’s life.
Right of First Refusal
A Buy-Sell Agreement may also grant each owner a right of first refusal upon the other owner’s desire to sell his all or part of his ownership interest. If any owner desires to sell any portion of his ownership interest (the Selling Owner), the other owner (the Non-Selling Owner) will have a right to force the Selling Owner to sell his or her ownership interest to the Non-Selling Owner.
The purchase price for an owner exercising his or her right of first refusal will typically be a function of any bona fide offer received or made by a Selling Owner to transfer the Selling Owner’s ownership interest. The Non-Selling Owner would be required to purchase the Selling Owner’s ownership interest at the price and on the terms and conditions of the bona fide offer.
Importantly, the Non-Selling Owners would have the option and not the obligation to purchase the Selling Owner’s ownership interest. If, within a specified timeframe, the Non-Selling Owner choses not to purchase the Selling Owner’s ownership interest, the Selling Owner may sell his or her ownership interest to a third party.
“Russian Roulette” Provision
The Russian Roulette provision (or what my colleague likes to call a “Candy Bar” provision) offers an owner an opportunity to buy out, or to be bought out by, the other owner in the event of a deadlock in management. This provision offers each owner the chance to trigger a mechanism which will result in one owner buying out the other owner, effecting a complete ownership shift.
So, how would this work? Either owner may deliver notice (the “Initiating Owner”) of his or her exercise of the Russian Roulette provision to the other owner (the “Responding Owner”). The notice will contain a purchase price at which the Initiating Owner offers to either buy the Responding Owner’s ownership interest or sell the Initiating Owner’s shares to the Responding Owner. In other words, the Initiating Owner breaks the candy bar in half, and the Responding Owner chooses which half to eat.
The Russian Roulette provision is a last resort provision, but provides owners of closely held businesses a way out of a tricky deadlock situation.
In conclusion, whether you are starting a business or maintaining a successfully run business, a prudent entrepreneur should consider all succession options available before it’s too late.
