FROM ONCE UPON A TIME
TO HAPPILY EVER AFTER:
BUY-SELL AGREEMENTS
BY NICOLE M. VANCE, ESQ.
Once upon a time, there was a client with
a successful business, a happy family,
good health and money in the bank.
All was well until his partner declared
bankruptcy, got divorced then died
unexpectedly. Alas, the client had ignored
advice to implement a buy-sell agreement
1
for his business. Consequently, he lost
his business, and he and his remaining
partner
2
are depleting their savings
fighting in court with their deceased
partner’s bankruptcy trustee, ex-spouse
and executor. The client himself is
heading down the same path; his wife is
divorcing him, his children won’t speak to
him, his savings are gone and his health
is failing due to ongoing stress. He no
longer speaks to his advisors out of fear
they might say, “I told you so,” or at least
raise an eyebrow.
All right, perhaps this is a slightly exaggerated case;
however, we have all seen similar situations, and this story is
hopefully persuasive for any client thinking buy-sell planning
is unnecessary. Of course there are circumstances where a
buy-sell is unwarranted, namely for clients that:
1. Do not mind being in business with their deceased
partner’s spouse, children, pets or, worse, a
bankruptcy trustee, executor or unknown third party;
2. Do not care how the business is valued if a partner’s
interest must be bought out; or
3. Have no concern over whether funding is available
for such buyout.
I have yet to meet a business owner with partners that
fall into any of these categories. In the unlikely event such a
person exists, this is almost certainly due to lack of education.
In short, a comprehensive buy-sell agreement is the best
way to protect a business and its owners. The purpose of this
article is to provide a general overview of buy-sell planning,
including the specic factors clients must consider in
implementing a buy-sell agreement.
Who Needs a Buy-Sell Agreement?
Every business owner with one or more partners needs
a buy-sell agreement. This is true whether or not the other
10 Nevada Lawyer December 2012
December 2012 Nevada Lawyer 11
continued on page 12
owners are original owners, friends, family members, silent
investors or key employees.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a binding agreement between
business owners that governs what happens upon the
occurrence of certain unexpected “triggering events,” such as
the death or departure of an owner. It sets forth the specic
terms and conditions applicable to an ownership transfer
caused by a triggering event. Essentially, a buy-sell is the
business equivalent of a prenuptial agreement. A buy-sell is
not required by law but makes good business sense.
Any type of entity with multiple owners may have a
buy-sell. The agreement may take the form of a standalone
agreement, a shareholder’s agreement for C corporations or
S corporations, an operating agreement for limited liability
companies or a partnership agreement for partnerships.
When to Implement a
Buy-Sell Agreement?
Ideally, a buy-sell agreement should be in place from
business inception. Practically, however, a buy-sell may be
implemented at any time as long as the owners can agree on
key terms. This is important because owners often neglect
buy-sell planning as they focus on getting the business started
and soon after are consumed with daily operations. Some
business owners wait years before getting the buy-sell done.
Nevertheless, sooner is better when it comes to such planning.
Why Have a Buy-Sell Agreement?
A buy-sell is necessary to protect the business, the owners
and the owners’ heirs. It eliminates or reduces uncertainty
regarding the terms and conditions of ownership transfers
upon the unexpected departure of an owner. A well drafted
buy-sell:
1. Prevents undesirable owners from acquiring business
ownership;
2. Creates a market for a departing owner’s interest;
3. Establishes a methodology for calculating the price of
the ownership interest; and
4. Determines the appropriate method for funding the buyout.
By accomplishing these objectives, buy-sell planning
allows the owners to preserve their wealth, both inside and
outside of the business, and thus maintain their own personal
nancial security.
How to Draft a Buy-Sell Agreement?
Seven key factors should be to be considered and addressed
in a buy-sell agreement. As a buy-sell is unique to each business,
it must be customized based on the goals, objectives and
circumstances of both the business and its owners.
Type of Agreement
There are two types of buy-sell agreements: cross
purchases and redemptions. In many cases, agreements are
drafted as a hybrid of the two.
In a cross-purchase agreement, the remaining owners have
the option or obligation to purchase a departing owner’s interest.
This type generally works well for businesses with fewer
owners. A cross-purchase agreement is advantageous because:
1. The buyers take a stepped up basis;
2. Insurance funding does not subject the proceeds to
the alternative minimum tax (as can happen with
company redemptions);
3. The proceeds are not subject to the reach of company
creditors;
4. Loan agreement and state law redemption restrictions
generally do not apply; and
5. The tax expense is lower since the interest is purchased
using after-tax dollars and individual owners are
generally in a lower tax bracket than the business.
With a redemption agreement, the company has the
option, or obligation, to purchase a departing owner’s interest.
This form works best for businesses with many owners.
Advantages include:
1. Simplicity, as only the company and departing owner
are involved;
2. Less complex insurance structuring because fewer
policies are required;
3. Increased nancial security since the company is
often better positioned to fund the buyout; and
4. Deductibility of interest paid on installment
payments (usually).
Prohibition on Sale and Right of First Refusal
The agreement should prohibit the sale or transfer of
a departing owner’s interest to any third party without the
written consent of the remaining owners. In addition, right of
rst refusal language should be included, giving the company
and remaining owners the option to buy such interest.
Triggering Events
Various unexpected circumstances must be contemplated
in a buy-sell agreement. These are commonly referred to as
“triggering events” and should include the following with
respect to any owner:
1. Death;
2. Disability;
3. Divorce or legal separation;
4. Dire nancial circumstances, including bankruptcy or
insolvency; and
5. Departure, whether voluntary (e.g., retirement) or
involuntary (e.g., expulsion).
Owners should also consider including language that
requires automatic conversion of the ownership interest into a
nonvoting interest upon occurrence of a triggering event.
Purchase Rights and Obligations
For each type of triggering event, the buy-sell should
specify whether the resulting right to purchase the departing
owner’s interest is optional or mandatory. Additionally, the
12 Nevada Lawyer December 2012
BUY-SELL AGREEMENTS
continued from page 11
agreement must indicate whether such buyout right is to be
exercised by the company or the individual owners. More often
than not, both have buyout rights and, in such case, the buy-
sell needs to address the order of priority. For example, do the
owners have the option to purchase the interest only after the
company declines to redeem the interest? If the owners have
the right to purchase, and all remaining owners wish to exercise
such right, will each owner purchase the interest on a pro rata
basis or otherwise?
Valuation – Methodology and Date
The buy-sell agreement needs to establish a specic
methodology to value the interest of a departing shareholder,
and the valuation approach may differ based on the type of
triggering event that occurs. The agreement should also specify
the valuation date for each type of triggering event.
There are various approaches to valuation. These include:
1. Independent appraisal, in which case the agreement
should address required qualication of the appraiser;
2. Agreed-upon price;
3. Fixed price with provision for annual or other regular
review;
4. Formula;
5. Asset-based approaches, such as book value, adjusted
book value/net asset value, liquidation value;
6. Earnings-based methods such as capitalization of
earnings, net cash ow or gross cash ow, discounted
net cash ow or future earnings;
7. Market approach; and
8. Other approaches, including valuation of goodwill and
other intangible assets, excess earnings or multiple of
discretionary earnings.
Many buy-sell agreements provide that the departing
owner’s interest will be valued based on an agreed-upon price,
yet it is hard to reach agreement on price or anything else upon
an owner’s unexpected departure. Moreover, when value is
to be determined pursuant to “xed price with adjustments
upon regular review,” the required review has often been
neglected over time. In such circumstances, the buy-sell often
includes independent appraisal as a contingency. In any case,
business owners should consult with both their attorney and tax
professional to determine the best approach for their situation.
Funding
The rights and obligations in a buy-sell agreement mean
little when the purchasing party does not have funds for the
buyout. Funding is therefore a critical element to address so as
to ensure there is available means for payment.
Many buy-sells are fully or partially funded with “key
person” insurance, which provides coverage to protect the
company in case of an owner’s unexpected death or disability.
Another common form of funding is a seller-nanced payment
plan pursuant to a promissory note from the purchaser, whereby
a portion of the purchase price is paid up front and the balance
is payable over time. Payment terms commonly require regular
payments of interest and principal over a one- to six-year term,
and the purchased interest must be pledged as collateral by the
purchaser. Including provisions for a structured payment plan
provides a higher level of certainty that all potential buyers will
be able pay for the buyout if a triggering event occurs.
The funding strategy should accomplish various
objectives. Generally, these include creating liquidity,
providing nancial security for the departing owner and
family, mitigating nancial risk to the company and remaining
owners and minimizing taxes.
Spousal Waiver
The buy-sell should require that the spouses of all owners
execute a waiver of any and all rights to any ownership interest
in the business in the event of a divorce, legal separation or
otherwise. This is especially important in community property
states like Nevada.
Conclusion
Once upon a time, there was a client with a successful
business, a happy family, good health and money in the bank.
All was well until one of his partners unexpectedly retired.
Fortunately, this client was smart and had taken the time to
implement a comprehensive buy-sell agreement. As a result,
he and his partner exercised their option to buy out the retiring
partner for a fair price pursuant to a reasonable payment
structure. No court involvement was necessary, and the business
continued to prosper. More importantly, the client maintained
his marriage, happy family, good health and life savings. Thanks
to the buy-sell agreement, he lived happily ever after.
1 The terms “buy-sell agreement” and “buy-sell” are used
interchangeably throughout this article.
2 For purposes of this article, the term “partner” is used to refer to any
co-owner of a business, whether a shareholder in a C corporation or
S corporation, a member in a limited liability company or a partner
in a partnership.
NIcolE VANcE is an attorney with her own
practice, the Law Offices of Nicole M. Vance.
She works with individuals, families and entities,
advising her clients on estate and business
planning matters, including advanced wealth
transfer strategies, general estate and trust
issues, business formation and choice of entity, business
succession planning, charitable giving and asset protection
planning. She can be reached at nvance@nmvlaw.com.
