When you establish or run a business in California with multiple owners, navigating the complexities of succession planning is a significant consideration. Among the essential tools for this process is a Buy-Sell Agreement.

But do you really need one?

This article will delve into what Buy-Sell Agreements are, how to determine when you need one, their benefits and potential drawbacks for small business owners, how Buy-Sell Agreements are established, and how to fund them.

What are Buy-Sell Agreements

Buy-Sell Agreements, also known as buyout agreements or cross-purchase agreements, are legally binding contracts between co-owners of a business that outline the terms and conditions of a future sale.

These agreements act as a sort of pre-nuptial agreement between business partners and specify how ownership interest should be divided in the event of certain triggering events, such as the death, disability, or departure of an owner. They also provide a roadmap for the remaining partners on how to manage such situations, thereby reducing potential conflicts and ensuring the smooth transition of the business.

How to Determine When Buy-Sell Agreements are Necessary?

Determining the necessity of a Buy-Sell Agreement ultimately depends on the specific circumstances of your business, but there are some common instances when they should be considered.

Business Entity with Multiple Owners

If your business has multiple owners and you want to ensure its continuity irrespective of future unforeseen events, a Buy-Sell Agreement is advisable. It becomes especially important when considering potential scenarios such as retirement, disability, divorce, or death of co-owners. In such events, this agreement provides a clear plan for how ownership interest is sold or transferred, thus the Buy-Sell Agreement prevents disputes and protects the business from destabilization.

Solely Owned Businesses (Including Solely Owned by Legally Married Spouses)

If your business is solely owned, or owned solely by legally married spouses or registered domestic partners, a Buy-Sell Agreement may not be necessary (although succession planning is still a crucial aspect to consider).

Buy-Sell Agreement for Business Entities

A Buy-Sell Agreement is particularly beneficial if your business operations involve more than one business partner under an entity such as a limited liability company (LLC), Corporation (including closed corporations and closely held businesses), S Corporation, Professional Corporation, General Partnership, Limited Partnership, or Limited Liability Partnership.

These entities with two or more owners whose interests need to be protected and clearly defined are prime candidates for Buy-Sell Agreements because a Buy-Sell Agreement provides a clear procedure for dealing with ownership changes, meaning the Buy-Sell Agreement prevents disputes that could disrupt business operations.

Similarly, in a partnership or limited liability company, where personal relationships often play a more significant role, a Buy-Sell Agreement can manage potential conflicts by establishing a clear pathway for ownership transition. While a partnership agreement or operating agreement may contain some of the provisions of a Buy-Sell Agreement, standalone Buy-Sell Agreements generally contain much more information and details.

It is important that such business entities already have a strong foundation in their operating agreement, bylaws, or partnership agreement, and if any of these documents require work, this work should be completed prior to, or contemporaneous with, the drafting of a Buy-Sell Agreement.

How Buy-Sell Agreements Protect Your Business Interests

A Buy-Sell Agreement protects business interests in several ways:

Preventing Unwanted Third Parties from Acquiring Ownership

A Buy-Sell Agreement may stipulate that existing owners have the first right to purchase shares from the departing owner. This keeps the ownership within the established group and prevents unwanted external parties from getting a stake in the business.

Providing a Clear Valuation Method

A Buy-Sell Agreement sets out the method for valuing the business and business assets in the event of a sale. This helps prevent disputes over the value of the business and business assets when the time comes to buy out an interest of an owner.

Ensuring Business Continuity

Buy-Sell Agreements outline a plan for business continuity upon the happening of triggering events (such as the death, disability, or departure of a business partner). This means the business can continue to operate smoothly even in challenging circumstances.

Reducing the Potential for Conflicts

By establishing a predetermined plan for the distribution of an ownership interest upon the happening of certain triggering events, Buy-Sell Agreements may minimize the potential for conflicts among remaining owners or between the remaining owners and the estate of a deceased owner.

Facilitating Estate Planning

A Buy-Sell Agreement may act as a tool for estate planning. Under certain circumstances, it can provide liquidity for payment of estate taxes and ensure that the heirs of an owner receive a fair price for the business interest of the deceased business partner.

The Cons of Buy-Sell Agreements in California

While Buy-Sell Agreements offer many benefits, they also carry some potential drawbacks:

Creating Financial Strain

The requirement to purchase the ownership interest of a departing owner can potentially place a financial burden on the remaining owners or the business itself. Proper funding arrangements, such as insurance policies or a sinking fund, may be put in place to mitigate this risk.

Reducing Ownership Flexibility

The restrictions placed on the sale of ownership interests can limit the flexibility of owners to sell their stake as they wish. This could potentially hinder the ability of an owner to cash out their investment in the business but does protect co-owners.

Complexity and Cost of Drafting

Buy-Sell Agreements can be complex and require careful consideration in drafting to ensure all potential scenarios are covered. The resulting legal costs can be significant, particularly for a small business.

Rigidity

Once established, changing the terms of a Buy-Sell Agreement can be difficult and may require majority, super-majority, or unanimous consent of all owners. This could become problematic if circumstances change and the existing agreement no longer suits the needs of the business or its owners.

While Buy-Sell Agreements are a powerful tool for managing business succession and are recommended for all businesses for which they are appropriate, they are not without their detriments, and it is important to weigh these against the potential benefits before deciding to enter into such an agreement.

What Information Should be Included in a Buy-Sell Agreement?

Having a comprehensive Buy-Sell Agreement is akin to having a well-drawn map that navigates business partners through the labyrinth of potential hurdles related to ownership transition. With this in mind, the following are provisions that should be considered for inclusion in all Buy-Sell Agreements to ensure they provide an effective blueprint for handling such situations.

Restrictive Legend on Share, Membership, or Partnership Certificate

A restrictive legend on a share, membership interest, or partnership interest certificate is essentially a statement placed on the certificate indicating that the ownership interest represented by the certificate is subject to certain restrictions on transfer as spelled out in a Buy-Sell Agreement. The inclusion of a restrictive legend serves several key purposes:

Awareness

It makes any potential buyers or transferees aware that there are restrictions on the transfer of the ownership interest. This can prevent misunderstandings and legal disputes down the line.

Enforceability

The presence of the legend can assist in the enforceability of the transfer restrictions, as it is an overt demonstration that the owner was aware of the restrictions.

Regulatory Compliance

In certain jurisdictions, regulatory authorities may require that such legends be placed on the certificates representing ownership interests in a corporation or partnership.

The restrictive legend is an essential element that adds another layer of protection for business partners and helps maintain control over who can own an interest in the business.

Right of First Refusal

The right of first refusal is another key provision in a Buy-Sell Agreement.

A right of first refusal gives current owners the first opportunity to buy the ownership of an exiting owner before they are offered to an outside party. In essence, if an owner wishes to sell their stake, they must first offer it to the existing owners at the same price and on the same terms as they intend to offer it to an outside buyer.

This provision ensures that the current owners can control who enters their business circle and can prevent ownership from falling into unwanted hands.

Restrictions on Encumbrance of Business Ownership

Under a Buy-Sell Agreement, restrictions on encumbering business ownership can be essential for maintaining the integrity and financial stability of the business.

These restrictions prevent an owner from pledging their business interest as a security for personal debts, which could potentially place the business at risk. If the owner fails to satisfy their personal obligations, the creditor may have legal rights to seize the business interest. This can result in unwanted third parties gaining influence or control over the business, disrupting operations, and causing potential conflicts.

Therefore, these restrictions are necessary to protect the business and its owners from external liabilities and ensure the longevity and smooth functioning of the business.

Restrictions Upon Transfer

Placing restrictions upon transfer in a Buy-Sell Agreement is another crucial aspect aimed at ensuring the continuity and stability of a business.

These restrictions limit the ability of an owner to freely transfer their interest in the business, providing a safeguard against unwanted or unplanned changes in ownership. These restrictions provide all owners with a degree of control over the future of the business, allowing them to handpick successors and thus, maintain the strategic direction of the business.

Obligations of Permitted Transferees

A Buy-Sell Agreement can establish certain obligations for permitted transferees, which are potential new owners that existing owners have approved.

These obligations may include adherence to the terms of the Buy-Sell Agreement by the transferee, assumption of liabilities of the transferor by the transferee, entering into a non-compete agreement or agreement with non-compete clauses, participation in future agreements among owners, or other terms and conditions.

These obligations help protect the interests of the existing owners and the business, ensuring seamless continuity and operational integrity.

Triggering Events

Triggering Events are predefined circumstances that, when a triggering event occurs, activate the provisions of the Buy-Sell Agreement.

Having clearly defined triggering events is critical to avoid confusion about when a triggering event occurs or when a triggering event has not occurred, as the provisions of the Buy-Sell Agreement triggered are significant for both the owner triggering and the other owners.

Below are some examples of triggering events that should be considered for inclusion in every Buy-Sell Agreement.

Purchase Upon Death

A purchase upon death clause in a Buy-Sell Agreement stipulates that, upon the death of an owner, the surviving owners or the business entity itself has either the right or obligation to purchase the ownership interest of the deceased owner from the estate of the deceased owner.

Purchase Upon Disability

A purchase upon disability clause in a Buy-Sell Agreement states that, upon the permanent disability of an owner, the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the disabled owner.

Purchase Upon Termination of Employment

A purchase upon termination of employment clause in a Buy-Sell Agreement states that, upon the voluntary or involuntary termination of employment of an owner (which may be clarified to mean with or without cause), the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the terminated or terminating owner.

Purchase Upon Bankruptcy

A purchase upon bankruptcy clause in a Buy-Sell Agreement states that, upon the initiation of a voluntary or involuntary bankruptcy proceeding of an owner, the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the terminated or terminating owner to prevent ownership from being under the control of a bankruptcy trustee or subject to liquidation at a bankruptcy auction.

Purchase Upon Breach of Contract

A purchase upon breach of contract clause in a Buy-Sell Agreement states that, upon the breach of contract by an owner, the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the terminated or terminating owner. This may be drafted to mean only the Buy-Sell Agreement or may include other shareholder agreements, or any contract with co-owners or the business, such as an operating agreement.

Purchase Upon Felony Conviction or Willful Misconduct

A purchase upon felony conviction or willful misconduct clause in a Buy-Sell Agreement provides that, upon the conviction of a felony or upon willful misconduct of an owner, the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the triggering owner.

Purchase Upon Dissolution of Marriage or Registered Domestic Partnership

A purchase upon dissolution of marriage or registered domestic partnership clause in a Buy-Sell Agreement provides that, upon the initiation of proceeding for dissolution of the marriage or registered domestic partner of an owner, the other owners or the business entity itself has either the right or obligation to purchase the ownership interest of the divorcing owner to prevent ownership from being given, in whole or in part, to the estranged spouse or registered domestic partner in a dissolution proceeding.

Method of Valuation

Determining the value of a business interest is a crucial part of a Buy-Sell Agreement, especially in light of any triggering events.

A Buy-Sell Agreement may include a mutually agreed upon fixed price method of valuation among co-owners. This method could be based on a fixed valuation agreed upon annually, a formula based on multiples of earnings or revenue, or an appraisal by an independent third party effective on the date of the triggering event.

Including a predetermined method of valuation helps to avoid potential disputes and ensure a fair transaction. This aspect of the agreement guarantees that the price paid for the business interest reflects its true market value, protecting both the buyer and the seller during such a transaction.

Insurance Policies

A Buy-Sell Agreement may specify certain types of insurance policies to be held by the business or individual owners for the duration of the agreement. This is to ensure that funds are available when a triggering event occurs.

These types of policies can range from life insurance, which would be used to buy out the ownership of a deceased owner or disability buy-out insurance for cases where an owner becomes permanently disabled. The agreement may also refer to key person insurance, which provides compensation for any financial losses that might arise from the loss of a key individual within the business.

These insurance provisions guarantee financial security and operational stability for the business and owners in the event of unexpected circumstances.

Payment and Deferred Payments

The payment and deferred payments section of a Buy-Sell Agreement outlines the terms under which the purchase price for the business interest will be paid.

It is common to include a down payment at the time of sale, with the remainder of the purchase price paid over a predetermined period of time if the payment is not funded by insurance or a sinking fund. This arrangement allows for the transaction to be more manageable for the buyer and provides a steady income stream for the seller. The deferred payments are typically protected by a promissory note and/or security agreement.

The terms of the deferred payments, including the interest rate and payment schedule, should be clearly defined in this section.

Mandatory Dissolution for Failure to Purchase

The mandatory dissolution for failure to purchase clause in a Buy-Sell Agreement sets forth the actions to be taken when a designated buyer fails to purchase the business interest as required by the agreement. According to this clause, if a buyer does not fulfill their obligation to purchase, it can trigger the dissolution of the business entity itself. This clause serves as a protective measure, ensuring that all parties adhere to the stipulated terms, and provides a clear course of action in the event of non-compliance.

Termination Provisions

The termination provisions within a Buy-Sell Agreement outline the conditions under which the agreement may cease to be in effect. These can include predetermined dates, the completion of a certain action, or specific events such as the sale of the entire business.

One of the most common termination events occurs when there is only one remaining partner, effectively making the Buy-Sell Agreement unnecessary. At this point, the agreement terminates as there are no longer multiple owners to buy or sell interests when the last partner becomes a former partner.

Termination provisions are essential as they provide clear guidelines for the end of the agreement, helping to prevent potential disputes and ensuring a smooth transition for the business.

Preserving S Corporation Election

The section on preserving S Corporation Election in a Buy-Sell Agreement pertains to the necessary steps and protocols to maintain the status of a business as an S Corporation if the business is an S Corporation for purposes of income tax.

Funding Buy-Sell Agreements

Funding a Buy-Sell Agreement is paramount to its effectiveness and serves as the financial backbone that supports the execution of the agreement.

Without proper funding, the remaining business partners may struggle to purchase the shares of the departing owner, potentially leading to financial strain or instability within the business. Such financial difficulties may also force the remaining owners to seek external financing, which could result in unwanted third parties gaining a stake in the business.

Therefore, proper funding mechanisms, such as life or disability insurance policies, should be in place to ensure a smooth transition of ownership, preserve business continuity, and avoid potential conflicts or financial hardships.

Funding with Life Insurance

There are two primary ways to fund a Buy-Sell Agreement with life insurance: Cross-Purchase Agreements and Entity-Purchase Agreements.

Cross-Purchase Agreements

In a Cross-Purchase Agreement, each business partner purchases a life insurance policy on the life of each of the other owners. If an owner dies, the surviving owners use the death benefit to buy the share of the business previously owned by the deceased owner from the estate of the deceased owner.

Entity-Purchase Agreement

Under an Entity-Purchase Agreement, the business itself purchases a single policy on the life of each owner, and the business is the beneficiary. If an owner dies, the company uses the death benefit to purchase the share of the business previously owned by the deceased owner from the estate of the deceased owner.

Preference for a Cross-Purchase Plan for Step-Up in Basis for Surviving Owners

While both a Cross-Purchase Agreement and an Entity-Purchase Agreement will ensure that funds are available to facilitate the purchase of the share of the business previously owned by the deceased owner from the estate of the deceased owner, thus maintaining business continuity and stability, there is a tax benefit for the Cross-Purchase Agreement.

In the context of a Cross-Purchase Agreement, when the surviving owners buy the ownership interest of a deceased owner of the business, they realize a step-up in basis on the purchased shares. This means that the cost basis of the shares (the original value used to determine tax liability) is increased with the fair market value at the time of the death of the deceased owner. If the surviving owners later sell their shares, this step-up in basis will reduce their taxable capital gain.

Entity-Purchase Agreement does not provide this step-up in basis. The cost basis or the surviving owners remains their original purchase price, regardless of the current fair market value of the ownership interest purchased by the business from the estate of the deceased former partner. Therefore, if the business is later sold, the taxable gain will be larger, potentially resulting in a higher tax liability for the surviving owners.

While a Cross-Purchase Agreement is more complex and requires the purchase of a greater number of life insurance policies (which may be expensive and cumbersome using whole life insurance policies or just cumbersome with term life insurance policies), a Cross-Purchase Agreement can provide significant tax advantages over the Entity-Purchase Agreement due to the step-up in basis.

However, each business’s unique circumstances should be considered when deciding between the two types of agreements, and each business partner should consult their professional tax advisor for a complete understanding of the tax implications and tax consequences for income tax purposes, estate tax purposes, and general tax advice when choosing Cross-Purchase or Entity-Purchase terms.

Funding with Disability Buy-Out Insurance

Disability Buy-Out Insurance is another effective mechanism for funding a Buy-Sell Agreement.

Much like life insurance, in the event of a long-term disability of an owner that makes them unable to participate in the business, Disability Buy-Out Insurance provides a pre-agreed sum to the disabled owner, effectively buying out their share of the business.

This ensures that the business can continue to operate smoothly, without financial strain, and the disabled owner receives fair market value in the form of the insurance benefit paid. This insurance policy is particularly beneficial as it establishes the purchase price and also provides the liquidity to execute the transition.

Funding with Reserved Capital

Another viable method for funding a Buy-Sell Agreement for death or disability, or for triggering events other than death or disability, is through reserved capital or sinking funds.

This involves regularly setting aside funds into a dedicated account, which can then be used to buy out an owner upon the happening of a triggering event. The account should be jointly controlled by the owners and exclusively purposed for this specific need.

This method requires discipline and a significant period of time to accumulate the necessary funds, considering the high value usually associated with businesses. Moreover, if a triggering event happens prematurely, the funds accumulated might not be sufficient to cover the buyout, causing financial strain.

While a sinking fund provides a self-controlled and predictable funding solution, its effectiveness heavily relies on the timeline and the financial discipline of the business partners.

Key Considerations Before You Sign Buy-Sell Agreements

Before you sign Buy-Sell Agreements, several critical considerations must be carefully assessed. These include:

Valuation of the Business

It is vital to determine a fair and mutually agreed-upon value or valuation method for the business before signing the agreement. This ensures that all parties receive an equitable share in the event of a triggering event. Regular business valuations may be necessary to account for changes in the business’s worth over time.

Selection of Triggering Events

The agreement should clearly define the events that would trigger the buyout. Common triggering events include the death or disability of an owner, but other events such as retirement, bankruptcy, divorce, or disputes among owners could also be included.

Funding Mechanism

The agreement should outline how the buyout will be funded. This might be through life insurance, disability insurance, reserved capital, or other mechanisms. The chosen funding method should be financially viable for all parties.

Impact on Ownership Structure

Consideration should be given to how the buyout might impact the ownership structure and control. For instance, in a cross-purchase agreement, the remaining owners will have increased ownership shares, whereas in an entity-purchase agreement, the business retains the shares.

Tax Implications

It is crucial to understand the potential tax consequences of a Buy-Sell Agreement. For instance, the step-up in basis benefit offered by a Cross-Purchase plan can provide significant tax advantages. Engage a professional tax advisor to understand the possible tax implications fully.

Legal Counsel

Finally, consider engaging an experienced corporate attorney to ensure that the agreement is legally sound, fair to all parties, and aligned with the long-term goals of the business and business partners.

Drafting an Effective Buy-Sell Agreement in California

Do not leave your business vulnerable to uncertainty. Secure the future of your business by drafting an effective Buy-Sell Agreement with the experienced attorneys at San Diego Corporate Law. We are committed to providing comprehensive legal support tailored to your unique business needs. Contact us today and let us guide you through each step of the process to ensure a seamless transition during triggering events.