If your business has more than one owner, having a buy-sell agreement in place is vital. A buy-sell agreement is used to determine in advance how a potential sale of the business (or a portion of the business) will transpire. Navigating these decisions ahead of time can provide peace of mind and financial security for business owners.
If you are contemplating the creation of an agreement with your business partners, or if you are reviewing an agreement you already have in place, consider the following:
1. What will be the sales price?
Multiple methods are available to determine a price for your business sale: (1) You can use a formula based on assets owned by the business, gross revenue, or net profits. (Often the formula will be a combination of these factors.) (2) The owners can agree to an independent appraisal. (3) Occasionally, the agreement will define the price. (This tactic is uncommon unless the sale is imminent.)
Some advantages of using a formula are that it provides a level of certainty, and it forces a conversation between the business partners of what is most important for you and your business. Some downsides include that the formula may not reflect the actual value of the business, and people may be motivated to maximize the value of the business. An owner could have incentives to focus on one area of the business while ignoring others. For example, if the formula is revenue based, one owner may be motivated to grow revenue without keeping an eye on profitability.
The appraisal method also has advantages: Perhaps the appraised value will better reflect actual market value better than a formula. Negotiating a formula with your partner can be stressful and time-consuming. Sometimes it is best to agree to use an appraisal so that you can focus on other, more important aspects of running the business. The primary downsides of using an appraisal are its uncertainty and cost. If you are nervous about uncertainty, you may provide a provision allowing for one party to pay for a second appraisal that will be averaged with the original.
2. What is the payment period?
Do you expect the buyer to pay cash? Will the seller finance the purchase over a term of years? If so, for how long, and at what interest rate? If the seller finances the loan, he may have opportunities for tax deferral and reduction.
As a seller, receiving cash is appealing and reduces your risk. For the buyer, having the seller finance a portion of the sale could further align the seller’s interest in maintaining a thriving business after the sale.
Remember the provisions are intertwined. You can negotiate the price and payment period simultaneously. For example, if one partner is nervous about paying cash, that partner may be able to negotiate the purchase price.
3. Do you want restrictions on who can own the business?
You likely do not want an unknown business partner, so decide in advance to whom the business owners may transfer their ownership without the approval of other business owners. You may want to consider a right of first refusal to the other business owners, and include provisions for what happens to shares when the owner is no longer an employee, what happens to shares if an owner is fired for cause, how to manage divorce or legal trouble of an owner, and/or how to manage the death or disability of a business owner.
4. As part of the buy-sell agreement process, you may want to have a non-compete agreement (as a separate document).
A non-compete agreement will provide some protection from competing with a former partner after a business transaction. A non-compete agreement will likely have both time and geographic limitations on its enforceability.
5. How does the document work as a whole?
Finally, when you review the document, think through how the buy-sell provisions will work together. How will you feel if you are buying someone else’s shares? How will you feel if someone is buying your shares? Having an effective buy-sell agreement requires a delicate balance of being fairly compensated for your ownership interest while still ensuring the business will be sustainable when the buyer is making payments to the seller.
Thinking through these provisions with your partners can be stressful under ordinary circumstances. However, think about how relieved you will be when you do not need to negotiate these provisions when you are under the stress of a sudden need to sell. Having a thoughtful agreement benefits your future self as well as your business.