Buy Sell Agreements

A buy sell agreement allows you and your partners to plan ahead for when a partner leaves the business.

In going into business with others, whether it be a partnership, company or trust arrangement, it is important to consider what will happen in the event of change.  Change can occur in many guises – illness; death; relationship breakdown; retirement; change of direction – and so the question arises as to how the parties will deal with a change in the structure, that is to say ownership and management, of the business.

You have a choice. You can wait for something to happen and then try to deal with it at that point, bearing in mind of course that it may be an emotional time and the parties may not have made the necessary financial arrangements, or, the parties can anticipate a range of ‘what ifs’ and put measures in place. A buy sell agreement allows you and your partners to plan ahead for when a partner leaves the business.

Buy Sell Agreements

A buy sell agreement (or a buyout agreement as it is sometimes called) is a contract between all the partners in a business that deals with the future ownership of the business and partnership change. In this article we speak of partnership in the generic sense – it can equally be a change in shareholding or unitholding.

Because a buyout agreement is a binding contract, it can either stand by itself or it can be included inside a partnership agreement, shareholders agreement or unitholders agreement. These agreements deal with decision making; funding; planned transfers of ownership; dispute resolution; etc but may not necessarily address the need for a buy sell arrangement caused through a premature trigger event.

Generally, a Buy Sell Agreement will address issues such as:

  • Whether a partner can be bought out when they depart the business
  • The amount at which an ownership interest will be valued (valuation formula) when a partner leaves
  • Who can buyout a partnership interest when a partner departs (this can include outsiders to the partnership, but is often limited to pre-existing partners – these are known as pre-emptive rights)
  • What events can trigger a buyout
  • How a buyout might be funded

Trigger Events

As noted above, a buyout agreement will generally spell out what kinds of events will trigger a buyout option. These events typically include:

  • The retirement of a partner
  • A divorce settlement agreement in which a former spouse of a partner is going to receive an ownership interest in the business
  • An attractive and lucrative offer from an outsider to buyout a partner’s interest
  • A foreclosure of a debt secured by a partnership interest
  • The filing for personal bankruptcy by a partner
  • The death, permanent disability or incapacity of a partner.

Funding

The type of business and its rate of growth will dictate the amount that might be required to buyout a partner’s interest at any particular point in time.

While the business is small, the parties may be able to acquire the interest from their own funds or personal borrowings.

As the business grows and accumulates assets and goodwill, it usually becomes necessary to take out some form of life or keyman insurance in order to raise the necessary funds. There are different ways of making these arrangements depending on the particular circumstances and of course tax considerations must be borne in mind.

For example, business partners might purchase life insurance policies on the lives of themselves or each other. In the event of one of the partner’s death, the other partners will be paid a lump-sum benefit that is then paid to the deceased’s surviving family. This payment allows the surviving partners to acquire the share of the partner who has passed away while compensating the deceased family.

At a point the business may become too valuable to acquire an interest from personal resources or insurance premiums might become excessive in which case it would be necessary to sell to third parties or offer the entire business for sale.

Valuation

Valuations of private businesses is difficult in that there is no ready market for their sale and there are a considerable number of variable factors including issues such as the degree of management control attaching to a particular ownership; terms of the partnership agreement; importance of the departing partner; accounting practices; dividend stream; future projections and the business’ overall risk profile.  Many industries have a ‘rule of thumb valuation’ (e.g. ‘3 times EBIT’) but these often bear little relationship to what might be a true valuation.

The Buy Sell Agreement may specify that the business will be subject to annual valuation based on a particular methodology and so in the event of a trigger event in the ensuing year the valuation is already fixed, or it might provide a formula for valuation on the happening of a trigger event.

Summary

Undertaking a Buy Sell Agreement not only serves to make the partners consider the ‘what ifs’, it will also remind all the partners of how you have all agreed to handle the sale or buyback of an ownership interest in the event of partnership change.

If you and your partners do not have a buyout agreement, it can all become very messy and expensive and your partnership might have to be dissolved or wound up if you do not have arrangements in place.

Even if your partnership is not coming to an end, you and your partners may still disagree on who should buy out an ownership interest of a departing partner and how the ownership interest should be valued.

Buy Sell Agreements can also dictate what kinds of outsiders can buy into a partnership. If you do not have an agreement in place, you may end up running your business with someone you don’t get along with or who does not share the same vision and values.

Lanyon Partners can assist on all aspects of Buy Sell Agreements. If you have any questions regarding Buy Sell Agreements contact Jess Hill of our office.


The information contained herein is of a general nature only and is not intended to be relied upon nor is it a substitute for appropriate professional advice. Whilst all care has been taken in the preparation of the material, it is not guaranteed to be accurate. Individual circumstances are different and as such, require specific examination. Lanyon Partners cannot accept liability for any loss or damage of any kind arising out of the use of or reliance upon all or any part of this material. Additional information may be made available upon request.