Family members who enter into a private business together are taking on double risk. They face the same types of challenges that all owners and investors face in operating/investing in a business, but they are also exposed to the risk their personal relationships may suffer if the company does not fare well. For this reason, the decision to adopt a buy-sell agreement (BSA) – a type of corporate prenup – may be even more important for owners of family businesses. The BSA provides a clearly defined path governing how a partner exit will take place when the co-owners are in conflict about their roles in the business or the direction of the company. Family business owners are hardly immune to disagreements that can arise among business partners, and this post discusses some of the significant benefits that owners/investors in family businesses can secure by entering into a carefully drafted BSA.
What Are the Advantages of a Buy-Sell Agreement?
According to Forbes, as of in 2021 there are nearly 32 million small businesses in the United States. Yet, the Small Business Association estimates that only a fraction of these closely held companies have a BSA entered into by the owners. These sobering statistics may be even more applicable to family businesses, because in our experience, most family business owners do not take the steps required to evaluate and adopt a BSA before forming their companies or taking in family members as investors in the business.
We view the BSA as a critical step in careful business planning. Family members, like other business partners, may enter into a business venture together with the best of intentions, but people and their financial needs can change over time. We are all subject to the four Big Ds: divorce, disability, dysfunction and death. And any of these may lead to a fifth D – departure from the business. A business divorce between partners may become a necessity if any one of these four Big Ds takes place, which can impact family members just as they do other partners. When a separation becomes necessary, having a defined partner exit plan in place – a form of BSA – will limit the conflicts that arise as the partners go through the business divorce process.
For majority owners, the BSA provides owners with a contract right and mechanism to remove minority investors from the business who have become too difficult or demanding. For minority investors, the BSA provides them with the right to secure a buyout that enables them to monetize their ownership interest in the business if they become dissatisfied with the actions of the majority owner or of the management team. Thus, the BSA limits conflicts when a business divorce becomes necessary, because it provides for the orderly removal of partners and governs the specific terms on which the exit of a business partner takes place.
When business partners have not adopted a BSA, the likelihood of conflicts between them leading to litigation increases dramatically. And litigation among business partners is often bitter and prolonged, which may severely damage, if not end, close relationships among family members. Internal disputes and litigation between business partners will also likely cause major disruption to the company. Thus, having a well-drafted BSA in place almost always outweighs any possible disadvantages that may result. The following discussion reviews some of the most important benefits that can be achieved when partners make the decision to enter into a BSA:
- BSA provides a clear path forward – The BSA provides for the departure of partners in a manner that limits conflicts between them. When no BSA exists, minority investors may become disgruntled because they have no path to an exit, and they may engage in disruptive actions that create problems for the business in efforts to force a buyout of their interest. Similarly, the majority partner may become frustrated no means exists to secure the removal of a minority partner, who is causing problems for the business and the other partners.
- BSA sets forth a transition plan – In addition to providing co-owners with a clear exit path, the BSA also assures continuity of the business for its customers, creditors, and employees. A BSA defines the manner, method and timing of partner exits, including how the partner’s interest in the business will be valued at the time of exit. Thus, a BSA provides a clear set of rules that govern when a partner retires, dies, becomes disabled, is subject to a divorce, or is terminated. The BSA also applies when a voluntary sale of the business takes place, and in all of these instances, the BSA limits disagreements between the partners.
- BSA establishes price point and exit process – A well drafted BSA sets forth the payment terms for the minority interest after the value is determined, along with the method for funding the payment. Valuation is often a hotly contested issue, but the BSA will specify in detail how the interest of the departing partner will be valued to avoid these conflicts as much as possible.
- BSA creates an effective dispute resolution mechanism – To the extent that disputes arise between co-owners, the BSA sets forth a clear method for resolution, which is generally through a fast-track arbitration process. Thus, a comprehensive BSA helps partners to address disputes in a way that either avoids or reduces the time, stress and substantial cost that would otherwise result from becoming involved in litigation.
Key Elements of a Buy/Sell Agreement
There are four chief elements of a BSA, which are discussed below. These are not cookie-cutter documents. Terms need to be considered by the co-owners with input provided by counsel who are experienced with these agreements, so they are able to reach an agreement that meets their specific needs. Each of the parties is advised to have separate counsel to provide them with guidance that helps meet their business objectives.
Determine how the BSA may be triggered
The first key provision of a BSA is the trigger point, i.e., the point at which the BSA can be exercised by either party to the agreement. Generally, majority owners will have the right to buy the minority owner’s interest when he or she (i) files bankruptcy, (ii) gets divorced, (iii) dies or (iv) leaves the company. These are private companies, and the majority owner does not want to be forced to accept strangers injected into the business, as these situations could lead to that possibility. But majority owners also want to have the right to pull the trigger and buy out the minority investor at their option so they can remove any disgruntled/difficult minority partner.
On the other side of the coin, the minority investor does not want to be required to exit the business before the company appreciates in value. The investor may therefore insist that the BSA prevents the majority owner from triggering a buyout of the minority interest less than three to five years after the investment is made. In addition, and importantly, the minority investor will also want to insist that a look-back provision be part of the BSA, which ensures that the minority investor will not receive a below market value if the majority owner buys the investor’s interest and then promptly sells the company (or a share of the company) for a higher value than used to pay the investor for its interest. If the majority owner redeems/purchases the investor’s interest and then sells the business (or a substantial stake in it) in a fairly short period of time for a higher value, the look-back provision will require the majority owner to make a “true up” payment to the investor based on the increase in value. The length of the look-back provision is negotiable, but it is often in place for a full year after the majority owner buys the investor’s interest.
Finally, while the minority investor may want to be able to demand a buyout whenever the investor desires to exit the business, the majority owner is unlikely to agree to permit the investor to pull the plug shortly after investing in the company. The majority owner may therefore insist that the minority investor cannot exercise a redemption right for at least three to four years (or longer) after the investment is made. This gives the majority owner a set period of time before the investor can withdraw its investment. The majority owner may also require that all of the investor’s stake in the company be redeemed at one time to preclude multiple exercises of buyout rights.
Determine How to Value the Redeemed Interest
There are guidelines for valuing a private company, yet highly regarded valuation experts frequently reach different opinions about the value of the business and the value of the investor’s interest in the company. Given the importance of the purchase price to be paid to the departing partner, the co-owners should focus on how they want to determine the value of the company and purchase price when a business divorce takes place. It is often helpful to retain a business valuation expert to help draft the valuation provision and how the process will take place.
The major elements that the parties will need to consider in determining the value of the redeemed interest include:
- What is the valuation date (should it be the date the buyout is triggered, or a specific day of the year, e.g., December 31, regardless of the trigger date)?
- Should the value be based on a single date/point in time, or should it reflect a composite/average of the company’s value over the past two to three years?
- After the value of the business has been determined, should minority discounts be applied in calculating the value of the interest held by the minority investor, which are discounts based on the lack of marketability and the lack of control that are often applied when valuing minority held interests in a private company?
- Should the value of the company be based on a specific formula applied to the company’s financial performance (e.g., a multiple of the company’s revenues or earnings), or should the value be determined by business valuation experts who will rely on several different valuation methods? If so, how is the expert selected, and how are disagreements with the expert’s opinion resolved?
Further, agreeing to retain a business valuation expert to determine the value of the redeemed interest will not suffice to address all questions about the valuation process. The expert needs to be instructed by the parties whether or not to apply minority discounts to the company’s value, what the date of valuation is, whether a single valuation date is being used or whether the value determination should be based on an average of the company’s performance over a set period of years, and finally, whether the company’s value should include or omit retained earnings and/or working capital. All these issues need to be spelled out in the BSA.
The BSA will also provide the payment terms after the value of the redeemed interest has been determined. In most cases, the purchase price will be paid over a period of years after an initial payment is made. Therefore, the partners will need to document in the BSA (1) the rate of interest to be paid on the balance of the purchase price; (2) whether the majority owner will provide any collateral in the event of a default in payment; and (3) what rights/remedies the minority investor will have in the event of a default in payment by the majority owner.
Select a Prompt, Efficient Conflict Resolution Process
The final element of the BSA is the dispute resolution mechanism. It is not uncommon for partners to have conflicts over the value of the redemption price even when the BSA details how the value will be determined. Rather than allowing these conflicts to become the subject of protracted, expensive litigation that is carried out publicly in the courts, the parties can agree to make their disputes subject to a mandatory arbitration provision.
Arbitration is a matter of contract, and the parties can structure the arbitration to meet their needs by limiting scope, duration and timing of the arbitration proceeding. For example, in the BSA’s arbitration provision the parties can choose just one arbitrator or a panel of three; they can limit the scope of discovery permitted before the final hearing; they can require the final hearing to take place in just 60-90 days after the arbitrator (or panel) is appointed; and they can eliminate any potential award for lost profits or punitive damages by the arbitrator(s). This type of a fast-track arbitration allows the parties to agree to conduct a prompt, cost-effective and private resolution of their disputes without a public airing of grievances, which may hold significant appeal to family members who are in business together.
Family dysfunction is the subject of countless books and movies, and those conflicts exist in family businesses, as well. One way to avoid or at least narrow the scope of the conflicts when family members enter into business together, however, is for them to adopt a BSA at the outset. The BSA provides for a defined partner exit, which the parties can carefully negotiate to protect their interests as majority owners or minority investors if a business divorce becomes necessary. While no agreement can eliminate all conflicts, spending time on the BSA to pre-plan how a future business divorce will take place will help limit the issues that may be disputed in the future. Further, including a fast-track arbitration provision in the BSA will enable the parties to reach a prompt and cost-effective resolution of any future conflicts that do arise.