Buy-Sell Agreements

How to Avert Disaster in Your Business Partnership

As a business owner, one of the earliest decisions you will make is how to build your team. Should you run the business on your own, or take on partners? There are strong arguments both for and against partnering with others and sharing equity; however, we would like to focus on a different aspect of partnerships that many do not think about - until it is too late. While partnerships are almost always formed with the best of intentions, it is important to have a mutually agreed framework for ending the business relationship BEFORE it is needed.

If you have made the decision to set up a multiple shareholder business, consider the following scenarios:

Scenario 1: A dispute arises between two business partners, and one partner wants out. The controlling shareholder restricts dividends and other income that could be derived from the business investment.

The challenges:

• With the contentious nature of the relationship, how can the partners agree on an appropriate process for buying out the shares?

• How are the rights of the minority (non-controlling) shareholder protected?

• Can an agreement be reached without the threat of litigation, significant legal costs and further ill will?

Scenario 2: One of several partners in a privately held business dies unexpectedly. Her estate must be settled, with the value distributed according to her will.

The challenges:

• The surviving business partners either do not have the cash or are unwilling to agree on a price for the shares held by the estate.

• They want to restrict any external purchase of the shares.

• The surviving business partners want to force the sale of the shares, while the heirs want to retain their ownership stake in the business.

Scenario 3: A married couple are going through a divorce. The husband started a business with a business partner several years prior to getting married, and the court has decided that the value of the business gained during the period of the marriage should be considered as part of the marital estate.

The challenges:

• Neither business partner wants the husband to sell his equity, as this will harm the business.

• Even if the equity were sold, the amount of compensation received is likely to be impaired by the need for a quick transaction.

• Without a previously agreed-upon valuation mechanism, the opinions of value provided by business valuation professionals may vary widely resulting in further delay, dragging out an already difficult divorce. As you can see, the events that can adversely affect a business partnership vary widely, and the lack of pre-determined terms for buying and selling shareholder stakes results in an array of challenges - all with the potential for disaster.

It is for these reasons that a buy-sell agreement is of the utmost importance in any business partnership.

What is a buy-sell agreement?

A buy-sell agreement can be thought of as similar to a business prenuptial agreement. Due to the uncertainty surrounding the timing and circumstances of shareholder exits (whether voluntary or involuntary), a well-constructed agreement will map out processes, contingencies, and dispute resolution mechanisms - before these triggering events occur.

It is generally appropriate for all privately-held businesses where there are multiple shareholders to have a buy-sell agreement in place - preferably before a partnership goes into effect.

Benefits of a buy-sell agreement include:

• Establishing a "fair', structured plan for a shareholder exit - this is particularly important during contentious circumstances.

• Enabling a smoother transition while normal business operation continues.

• Creating liquidity and a ready market to sell a business interest - exiting shareholders are more certain of being able to "cash-out" of their equity positions. In Bermuda, where there is a limited pool of buyers, this can be critical!

• Mapping out the events which will trigger the buy-sell - this aids in eliminating ambiguity and reducing possible disputes.

• Providing procedures for dispute resolution, removing emotion from the decision-making process.

• Pre-determining the process by which the business interest will be valued - this will save both time and money when it comes time for a shareholder to sell their stake.

• Assigning a value to the business interest without necessitating a purchase/sale transaction - this is particularly important in divorce scenarios!

• Protecting against unwanted new partners - this provides incumbent shareholders with an opportunity to either increase or decrease their existing shareholdings.

• Determining payment and financing terms.

Addressing the Critical Issues of your Buy-Sell Agreement

Your advisory team, with a legal, finance and business valuation background, can help you construct a buy-sell agreement that is appropriate to your needs and circumstances. We recommend the following process:

1 Choose the appropriate agreement structure. The three basic types of buy-sell agreements are repurchase agreements (in which the entity buys the interest from the exiting party), cross-purchase agreements (in which one or more existing shareholders buy the interest from the exiting party) and hybrid agreements (which may allow the founder first priority to buy the interest and other owners or partners the second option to buy).

2 Negotiate the major provisions. The provisions are the meat of the agreement and outline how exactly a business interest will be sold and to whom.

3 Determine value and price. Map out how the business interest will be valued and priced in support of the provisions. Will a business valuation professional be used? Will a previously agreed upon formula be used?

4 Determine triggering events. What events will trigger the buy-sell agreement? These can include death, long-term disability, voluntary or involuntary termination, or third party actions, such as personal bankruptcy or divorce.

5 Choose how the buy-sell will be funded. How will the exiting party be paid for their business interest? Will it be an all-cash transaction or can the transaction be financed? What insurance needs should be considered in order to provide immediate cash without causing financial harm to the company?

With all of the potential challenges of having a multiple shareholder business, you must be well-prepared. It is important to have a well-constructed buy-sell agreement in place in order to protect your interests, as well as those of your partners.

However, if like many local companies, yours does not have a buy-sell agreement, do not worry - you can have one created at any time in the business life-cycle. Should a dispute or other unforeseen event arise, you'll be relieved you did.

This article is part of a series reflecting on some of the 'best practice' issues and considerations relevant to private business owners or those considering entering private business. Asgill Post provides Business Intermediary Services: Business Valuation and M&A Assistance. For comments or queries, contact Kumi Bradshaw MBA, CBA, BVAL - kumi@asgillpost.com