People enter into small business partnerships based on a common interest and a common vision.
The hope for the future of your business tends to drive all decisions. But these halcyon days almost always pass and difficulties and disagreements arise.
Therefore, the smartest foundational business decision you can make is to hope for the best and prepare for the worst.
That decision naturally results in establishing a buyout agreement (also known as a buy-sell agreement) between you and your business partners at the outset of your business venture.
The core purpose of a buyout agreement is to protect the future of your business and preserve the value of the ownership interests.
In this guide, we will discuss both unforeseen and foreseen events that trigger a buyout and the essential elements of a partnership buyout agreement.
Events Causing a Buyout
You can place buyout situations in two general categories: unforeseen events and foreseen events. Each of these consists of several types, and each triggers a buyout method.
The most common types of unforeseen events are:
- Death—the death of a business partner through which an heir of the estate may obtain the business interest;
- Disability—the disability of a business partner through which a custodian or guardian may obtain control of the business interest;
- Divorce—the divorce of a business partner through which the ex-spouse may obtain the business interest; and
- Bankruptcy—a liquidation or reorganization of the debt of a business partner through which a third party may obtain the business interest.
Each one of these events removes your known business partner and replaces them with an unknown or unwanted third-party business partner. Clearly, you would like to have a say in who your business partner is.
Through a partnership buyout agreement, you have the opportunity to do so. Unforeseen events are bought out through a “right of first refusal” (ROFR).
The ROFR grants you, as the remaining business partner, the opportunity to buy out the departing partner’s ownership interest.
These events can be reasonably anticipated and are not subject to the unknowns of life. General foreseen events are:
- Vision differences—a business partner disagrees on the future of the business;
- Loss of interest—a business partner is not pulling their weight and is otherwise not engaged;
- The need for cash—for good or bad, a business partner needs an infusion of cash (e.g., to settle a civil suit or buy a vacation home); and
- Bad faith/operational paralysis—underlying tensions have erupted into a willful desire by a business partner to destroy the business through inaction or worse.
Any of these events eliminates the mutuality of the partnership. When mutuality is destroyed, the option to exit as a partner or to exit your partner should be available.
In these events, the buyout mechanism is called (depending on who is acting) a “put” or a “call”. A put means that the partner that desires to exit the business forces the other partners or the business to buy their ownership interest.
A call means that the non-existing partner or business unilaterally buys the interest of another partner and forces them out of the business. Note that the non-acting partner cannot prevent a put or a call; this point is extremely important.
As you can see, the correct partnership buy-sell agreement can manage both unforeseen and foreseen events to the benefit of the business and all involved.
A Buyout Agreement’s Essential Terms
Partnership buyout agreements can exist as stand-alone agreements or as terms in a business’s governing documents.
Partnerships and limited liability companies incorporate the buyout agreement into the partnership agreement or the operating agreement.
Corporations treat the partnership buyout agreements as stand-alone agreements commonly called “shareholders’ agreements.”
There are four essential provisions of a buyout agreement:
- Notice—upon a triggering event (e.g., death, a need for cash, etc.), the business partners have a certain amount of time to act whether by a ROFR or to respond to a put or call;
- Valuation—the formula that has been agreed upon to value the ownership interest;
- Payment—the terms to purchase the ownership interest; and
- Lookback—a period of time to participate in the turn-around sale of the business after a call is exercised.
At this point, we will explain each one of the above in a bit more depth. However, each requires extended consideration with a legal professional, and Massingill can provide such guidance.
A notice provision prevents surprises and allows each party to act fairly and without undue pressure. It creates an atmosphere of honesty and transparency. Valuation is critical in that each party can have widely divergent valuations.
This kind of dispute, without an agreed valuation mechanism, can cause operational paralysis. Common valuation methods include the “book value” of the business or hiring a business appraiser.
We also recommend including a tie-breaking method for valuation (i.e., if two appraisers disagree, then they appoint a third who determines value). Payment provisions allow for saleability.
Requiring the purchase to be all cash is equally unreasonable as a promissory note payable over 30 years.
Under common buyout payment terms, a cash down payment and a short promissory note for the balance appropriately balances the needs of the parties.
Look back prevents a partner from calling another’s ownership interest and then capitalizing on that purchase by selling the whole business shortly thereafter.
This provision allows the bought-out partner to realize some business sale gains for a period of time after the call event.
How a Business Law Attorney Can Help
A good partnership buyout agreement will positively impact your ownership interest’s value and the health of your business.
Massingill have decades of legal experience that can help you craft a customized partnership buyout agreement for your company.
Contact us today to see what we can do for you and your business.