Buy-Sell Agreements Should Contain a Right of First Refusal

A buy-sell agreement governs the terms and conditions under which a business owner can sell — or be forced to sell — his or her ownership shares/units in the business. In general, a buy-sell agreement is an attempt to plan for adversity if an owner has an untimely death, becomes disabled, ends up in bankruptcy, gets divorced, or wants to sever the business relationship. Some buy-sell agreements are preventative — that is, the agreement prohibits a sale to third parties without consent of the other owners. Another option is to include a right of first refusal in the buy-sell agreement to govern any instance an owner is allowed to sell his/her ownership interest.

In general, rights of first refusal are a set of provisions in a contract that give one party priority over another third party with respect to making a purchase or entering into some transaction. In the case of a buy-sell agreement, the company or the other owners collectively would be given the right to buy the ownership shares on the same basis as offered to the third-party purchaser. If the company/owners say decline the option then the sale proceeds to the third-party purchaser.

Rights of first refusal typically include the following provisions:

• Prohibition on selling the ownership shares/units in violation of the right of first refusal
• Timely and sufficient notice of impending sales of ownership share/units — 30 to 90 days or more prior to the expected closing of the sale
• Information from the proposed buyer — financial status, credit history, experience in the industry/business, etc.
• Timetable for exercising right of first refusal and for payment
• Remedy clauses in the event of breach

A good San Diego corporate attorney can help draft the necessary language and ensure that the right of first refusal has “teeth.” This means adding the right to specific performance, attorneys’ fees, and indemnity provisions.

There are many advantages of using rights of first refusal. First, it gives all the current owners some peace of mind knowing that their hard work will not be sold off to some random third party who may not share the same values and norms as the current owners. Other key advantages include flexibility, forewarning, and information sharing. The first comes into play because, if the right of first refusal condition arises, the obligation to purchase is not mandatory. The second and third are related in that, if the right of first refusal condition arises, the proposed purchaser must provide information and notice must be given in a timely manner. This gives everyone time to deal with the imminent changes in the business because, at minimum, one of the owners is separating from the business.

Note that these types of provisions will be enforced by California courts. A good example comes from the case of Le v. Pham, 180 Cal. App. 4th 1201 (Cal. App. 4th Dist. 2010). In that case, the right of first refusal was contained in the corporate bylaws. Le involved a California Pharmacy Corporation. The bylaws required any shareholder to give the other shareholders written notice of any intent to sell or transfer with the other shareholder having a right of first refusal. In that case, one of the shareholders wanted to sell and sent a notice of intent indicating that the sales price was $70,000, cash upon transfer. The other owners accepted and asked for 30 days to obtain the cash or financing. The selling shareholders did not respond and proceeded to sell their shares to a third party for only $24,000 and allowed them to pay in installments. As one can imagine, litigation ensued. Eventually, the California trial court agreed that the right of first refusal had been breached and set aside the sale to the third party purchasers. The trial court was affirmed by the Court of Appeals.

Contact San Diego Corporate Law

For more information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard’s law practice is focused on business, transactional, and corporate matters, and he proudly serves business owners in San Diego and the surrounding communities. Contact Mr. Leonard by email or by calling (858) 483-9200. Like us on Facebook; find us on Twitter.

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