The right buy and sell agreement can save a company.
Perhaps two dozen years ago we witnessed the destruction of a healthy business because a drunk driver struck one of the relatively young owners on his way home from work.
It went like this:
The two owners were in their early forties. Both were excellent businessmen, had succeeded as top executives in the past, wanted to start their own business, had the money to fund it and were making good progress entering a relatively new (high tech) market. Over the first two years they had grown to twenty three employees, had just signed their largest contract, had celebrated the success just a week before the death and the company had about four months of existence left.
They had no buy and sell agreement that would provide for what would occur if an owner died or became disabled. As such, a surviving spouse was suddenly the owner of half the stock in the company. She did not want to own it and needed cash flow. The cash flow was not going to be there in a startup company with one owner suddenly dead.
She was a broken hearted wife shattered by the death, had three children, two in private school, and she had never been in business but had taught high school for a few years before marrying and becoming a full time home maker. They had just bought an expensive house in a good neighborhood with a large mortgage and country club dues and she was sitting across the conference room table looking at the surviving owner and explaining to him that the salary paid to her deceased husband would have to be continued or she would lose the house.
And he was explaining to her that with her husband dead, the company was facing an economic crisis. Jim (not his real name) had been the main marketing and sales powerhouse in the company and without him the company would make less sales or would have to hire someone else at a large salary to take up the duties. There was no excess money to pay her. He offered her half the salary her deceased husband used to take home and told her that would be a stretch for the company. I could see he was deeply upset to have to tell her that, felt guilty and desperate. The owners had been good friends.
She responded that her brother was a lawyer and had told her she owned half the company, could sit on the board and make decisions along with the surviving owner…or veto his decisions…and would if he would not continue needed payouts. He tried to show her the financials, shoving them across the table. Eyes wet, she stood up, said her children would not be pulled out of school because of his figures, and walked out of the room.
He looked at me and said, voice tight. “I’m going to have to close the doors if she doesn’t calm down.”
She did not calm down. Indeed, once he closed the doors and started a new business, she hired a lawyer claiming he had stolen the old business by simply shutting down and opening the new business and for three more years they spent money on lawyers arguing over the corpse of the old business. She lost the home, of course. He spent close to a half a million dollars in fees before the matter ended.
The reverse problem in which the family of the deceased is ousted is equally common. In one case we saw, there were three stockholders and the deceased owner had owned a third of the company. The spouse was told that there was no money to buy out the stock, that she would receive a third of the proceeds if any dividend was paid out or the company sold…but there were no plans to sell the company or pay dividends at the time. Desperate, she asked them to buy the stock. They did not want it, told her so, and a few years later bought her interest out for pennies on the dollar. Since she was a minority owner and there is normally no obligation on the company to hire owners, declare dividends or sell itself, she had no effective power (or money) to fight it. They were within their rights to ignore her and she owned stock worth nothing to her.
None of this need have happened. The owners above could have fairly and inexpensively avoided the entire dispute if they had initially created a buy and sell agreement and the first company would still be running today in all likelihood and the wife could have sold her interest for a fair price in the second example.
They all needed a simple buy and sell agreement.
How such agreements work and some of the pitfalls in using them is explained in this article.
The Basic Plan of the Buy and Sell:
It is easy. Before anyone dies or becomes disabled, the parties execute an agreement providing for a buy out of the deceased or disabled owner’s interest for a formula. The spouses sign onto the agreement so that they are bound as well. Normally, there is a formula that is practical and reasonable, subject to second computation if either side objects, and a down payment with five or ten years to pay off the rest, secured with either guaranties or the stock purchased. Interest is paid and payments are usually quarterly.
The estate of the deceased shareholder benefits in knowing precisely what the cash flow will be and that a fair price will be created. Since the formula was created before either side knew if they were buying or selling, the formula is usually quite logical, often book value plus a multiple of gross or net earnings for goodwill.
The estate gets paid out over time and does not have to flex its muscle in the board room or trying to run a business.
The company benefits in knowing precisely what its obligation will be, having time to survive the crisis and pay it out, and retrieving the stock owned by the now deceased or disabled owner.
Often the company purchases life insurance on the owners so that at least the down payment is available in cash to start the buyout.
Arbitration with an attorneys fees clause is routinely put into the agreement so that expensive court process is avoided entirely. See our article on the Acid Test Clause.
All owners know their families will have some security. All owners know they will not face desperate emotional spouses demanding pay outs they cannot afford.
It is a win win situation. It is so useful and of such value to both the stockholder and the company that one wonders why it is not always executed.
There are reasons and those are discussed in the next section.
The usual reason every company does not have a buy and sell is simply ignorance and procrastination. They are either not advised to draft one or, facing several thousand dollars in attorney and accountant fees for creation of one, put it off until the money and time is more available…and never get around to it.
But there are other common stumbling blocks.
First, death and disability are never pleasant subjects, and like estate planning, are often put off simply because it is so unpleasant to factor them into one’s planning for the future.
Second, creating a fair formula and making sure the spouses sign off can be at times difficult tasks and each spouse must sign off on the agreement or it is very limited in its usefulness. As one owner put it to the writer, coming home with a buy and sell to have the spouse sign made for a difficult dinner.
This is particularly true when the buy and sell applies to dissolution of marriage or termination of an employee, two variations discussed in detail below.
Finding and funding life insurance for the owners, while not required, is often desired and may involve additional expense and delay and even medical examinations of the owners who are not young.
Lastly, since each shareholder and spouse must sign and since all are entitled to their own legal and accounting advice, the need to get consensus among the professionals can be time consuming, exasperating and increase the price.
But all the above detriments are minor compared to the catastrophe that can occur if a death or disability occurs.
The Usual Triggering Events:
Death is a common event which triggers the buyout, but it can also include the permanent substantial disability of an owner, again often funded with disability insurance. Careful provisions have to be created to define what is disability and how it is determined. The agony of the healthy owner advising a no longer competent co owner that he or she must retire can be extreme…and as necessary for the survival of the company as any other key employee decision.
We also usually recommend a provision providing for the purchase of the stock of a spouse involved in a dissolution of marriage. A divorce, at any time, is a traumatic event with spouses often arguing over the value of assets to be divided. It is all too common for divorce attorneys to argue that the stock owned by the divorcing owner is of tremendous value and the spouse should be bought out at inflated prices. The company then becomes involved in a difficult struggle as outside accountants seek to value the stock, examine its books while the divorcing owner is both distracted and facing the danger that a divorce court will overvalue the stock and saddle him or her with a tremendous burden. More than once a divorcing owner simply closed the company once he faced an evaluation of the stock that was, to him, outrageous.
Assuming the correct wording is in the agreement, a fair formula can eliminate that danger, create a buyout similar if not identical to that of what occurs in death, only the spouse receives one half the value of the stock (representing his or her community property interest) and the divorcing owner can repurchase from the company the stock it purchases from the spouse. If drafted correctly, these are fully enforceable against a spouse who changes her or his mind and seeks to use a fight over the value of the stock as a bargaining tool in the divorce.
Ending employment can also trigger a buy out if the company determines that it no longer wishes to have an owner who is not working full time. Often, this is an option of the company rather than a requirement, but care must be demonstrated here, for a minority owner may very much want to be bought out if he or she is outvoted in the company while the company may not want to fund a potential competitor. Non competes are also included in such provisions but face close scrutiny from the California courts.
In all the examples above, a fair and logical formula is essential. Too often this office has seen inappropriate or out of date formulas or, even worse, a provision that the owners will meet annually to set the value. Often owners do not agree on the value and even more often no such meeting occurs due to the press of business. Avoidance of that danger is a critical task of the attorney. Creation of a fair formula is the critical task of the accountant. Both professionals are needed for a well drafted agreement.
When Should the Agreement Be Drafted?
One client put it well: be sure to draft it before you die in an accident.
Clearly the cost and trouble of negotiating and creating the agreement is a distraction for the owners of a new company but delay puts the company at extreme risk and demonstrates a lack of planning for an owner’s family’s well being that could be catastrophic. As with insurance for home or car, it simply should be a requirement for any well planned business enterprise and should be created as soon as possible, funded with life insurance if affordable, and treated as one of those business tools that are essential for the well planned business, such as creating a limited liability entity, getting a good accountant and lawyer, etc.
Easily said, but the simple fact is that most startup companies have owners normally working twelve hour days, six or seven days a week and the thought of death or disability or divorce simply has to be put on the back burner when confronting a payroll in two weeks. We have found it useful to have such pressed owners establish deadline for the buy and sell, normally within two quarters of setting up the entity, and making that deadline be set in stone. With such “project” scheduling, most companies do accomplish the task.
The reader is advised to read "Buy and Sell Agreements - Pay Now or Pay Later" to get a view of what can happen if one waits too long to accomplish this vital task.
The least painful requirement for a buy and sell was witnessed by this writer not with a death but with disability and with a good agreement in place. The affected owner had suffered a concussion in what was supposed to be a touch football game and after several months of treatment it was clear that his ability to do the books had been adversely effected and his inability to concentrate was not going to go away.
He tried to hide it for months and only an audit by the venture capitalists made it clear that he simply no longer had the wherewithal to add value to the company. He sat in his office while the other owner was telling him that it was time to move on to a different career but not to worry, there was already a plan in place, the buy and sell, and he would not be cast out without some protection.
The disabled owner at first argued, but then broke down and was actually sobbing during that horribly painful scene. But the other owner was able to say something that seemed to make a difference. “Look, we planned for this possibility. We knew what we were doing. We knew that things like this can happen. We made preparations and we have a fair way to resolve this and make sure you have enough to keep going. We aren’t children. We are adults and we planned like adults…”
The disabled owner looked up, nodded, smiled, and said something I will always remember. “It was good that I was smart when I had the ability. It’s saving me now, isn’t it?”
It also saved the other owner from desperate guilt or the prospect of the venture capitalists closing the company.
Whether a start up or an existing company, this is a highly recommended protection for the company and its owners.