BUSINESS LAW & PLANNING STRATEGIES
BUY SELL AGREEMENTS

What Is a Buy and Sell Agreement?

A Business Buy/Sell Agreement (BSA) differs from a business sale and purchase agreement (BSPA). A BSA  is a legally binding contract that stipulates how, between or  among owners of a corporation, LLC or partnership,  a part owner’s share of a business may be sold and purchased as between or among the entity and its other owners, if a part owner dies or otherwise leaves the business. Most often, the BSA  stipulates that the available shares be sold to the remaining owners, the entity or both. A  BSPA, on the other hand, is an agreement between the owners of the business or the entity to sell all the shares or assets of the business to an outside third party.

Purpose of Buy-Sell Agreement

The purpose of a buy-sell agreement is to provide for an orderly transition of ownership interests on the occurrence of specified events. A carefully drafted agreement will anticipate potential issues that may upset the functioning of a small, closely held entity when an owner desires or is forced to sell his or her interest in the entity. Typically, a buy-sell agreement controls the circumstances under which an owner may sell his or her interest, who is a permitted buyer, and how the price will be both determined and paid.

A buy-sell agreement benefits the entity and its owners by

  • Allowing the remaining owners to determine with whom they will work and share control of the entity;
  • Preventing outsiders or heirs, whose interests may conflict with those of the entity or the remaining owners, from obtaining an ownership interest (see Tu Vu Drive-In Corp. v Ashkins (1964) 61 C2d 283);
  • Ensuring continuity of management and control by the remaining owners;
  • Increasing job stability for minority owners and key nonowner employees;
  • Providing for the orderly liquidation of the owners’ interests in the event of death, disability, retirement, or other forced or voluntary withdrawal ;
  • Preventing the continued involvement in the business of retired or inactive owners;
  • Providing capital gains treatment for retiring or disabled owners;
  • Creating a market for the shares of deceased, retiring, or withdrawing owners;
  • Generating cash to pay death taxes and estate settlement costs;
  • Fixing the value of the interest for estate and gift tax purposes;
  • Preserving the legal status of the business, such as professional corporation, limited liability partnership, or limited liability company; and
  • Preventing the loss of S corporation status by preventing the transfer of an interest to an ineligible shareholder (e.g., a corporation).

The buy-sell agreement can be drafted as a stand-alone agreement or incorporated in the entity’s operating agreement (e.g., as covenants within a shareholder agreement, limited liability company operating agreement, or partnership agreement). Obviously, great care must be taken to ensure that the entity’s operating agreement and the terms of the buy-sell agreement are consistent.

Many investors insist on a buy-sell agreement with the management of companies they fund. These agreements provide the investors with an exit strategy from a company that does not perform to their expectations. An investor typically can either retrieve its investment in an underperforming company or obtain enough additional shares to oust management or sell control of the company to others.

Basic contract law and drafting principles apply to buy-sell agreements. A buy-sell agreement that fails to reflect adequately or accurately a transaction or to describe and protect the client’s rights fails in one of its essential purposes. An imprecise or badly drafted buy-sell agreement may result in either a dispute regarding an ambiguous or incomplete contractual provision or a malpractice claim based on an inadequate buy-sell agreement that worked to the client’s disadvantage.

Mandatory or Optional Buy-Out

Business owners must decide whether the purchase or sale specified in the buy-sell agreement will be mandatory or whether the entity or remaining owners will only have an option (the right to buy) or the right of first refusal (the right to meet the terms of a third party’s offer). As a general rule, a right of first refusal alone is not sufficient to protect the original owners’ preferred succession of interests. If unrestricted transfers (either within the “preferred” group or outside it) are allowed, the remaining owners may not have sufficient funds or may for other reasons be unable to exercise a right of first refusal when a transfer is proposed.

In most situations, the withdrawing owner or the deceased owner’s estate should be obligated to sell if one of the goals of the buy-sell agreement is to limit owners to persons active in the business. From the viewpoint of the withdrawing owner or the deceased owner’s estate, the entity or remaining owners should be obligated to purchase the interest.

Absent an obligation to purchase, the entity or remaining owners may find there is no practical reason to purchase the interest of the withdrawing owner or the deceased owner’s estate if the interest is a minority one. It is unlikely that the withdrawing owner or the deceased owner’s estate will find a ready market for a minority interest in a closely held business. A minority owner in a closely held business typically derives little or no economic benefit as a result of owning the interest because he or she cannot require the business to make him or her an employee, officer, managing partner, or director of the business. Absent an employment arrangement, a minority owner may have no voice in the affairs of the business and thus is unlikely to receive any distributions with respect to its ownership interest. For example, a closely held C corporation is unlikely to pay substantial dividends because the dividends are not deductible for tax purposes, while reasonable compensation is deductible and will likely be maximized in favor of those in control of the corporation. Similarly, in an S corporation, partnership, or LLC, the owners of the majority interest, or the general partners or member-managers, will likely draw compensation from the entity for services rendered and use their control position to minimize the distribution of profits to the owners, unless otherwise agreed.

NOTE: Mandatory purchase obligations held by a corporation are risky because creditors may set aside the transaction and impose personal liability on the directors. See Corp C §§316, 500. Mandatory repurchase is often provided for only on the shareholder’s death, when life insurance is in place to fund all or part of the repurchase (an exception to Corp C §500; see Corp C §503).

The estate tax consequences to the deceased owner’s estate must be considered if the entity or other owners have only a right of first refusal, and the price at which the interest will be purchased is to be the price established under the agreement or the price contained in a good faith offer from a third party, whichever is higher. In this situation, the purchase price established under the agreement is not likely to be accepted by the IRS for estate tax valuation purposes because the actual price paid for the interest could be higher. However, if the entity or remaining owners have the right or obligation to purchase the interest at a price no higher than the price determined under the agreement, the buy-sell agreement should establish the estate tax value of the interest, provided the requirements of IRC §2703 are met or are not applicable. If the entity or remaining owners are not obligated to purchase the interest, the potential financial impact on the withdrawing owner or the deceased owner’s estate must be considered, particularly the need for sources of cash to pay estate taxes.

Events Commonly Triggering Buy-Out

The option or obligation to buy out a shareholder, partner, or limited liability company member is most often triggered by the following events, with events that traditionally trigger an obligation to purchase so noted:

An attempt to sell: When an owner seeks to sell his or her interest in the business, the business entity itself will usually retain a right of first refusal on the same terms as the third party offer or at a price set in the buy-sell agreement. If the entity is unable or elects not to purchase the interest, the other owners usually are given the option (sometimes described as a “right of second refusal”) to purchase the interest on a prorata basis. See Le v Pham (2010) 180 CA4th 1201 (breach of fiduciary duty for selling stockholder to attempt to sell to third party in violation of right of first refusal in corporate bylaws). Occasionally, that entity or its governing body may be given the power to designate another buyer or buyers. If neither the entity nor the other owners purchase the interest, the seller may dispose of the interest to an outsider. Ordinarily, such a sale must be consummated within a specified time and at a price and on terms no more favorable than those offered to the entity or other owners; if the sale is not consummated, the rights of the entity and the other principals are reinstated.

Death: The death of an owner (shareholder, partner, or member) almost always triggers the obligation to purchase the decedent’s interest by the entity or by the surviving shareholders, partners, or members.

Retirement: The agreement may provide that an owner who is active in the business may or must have his or her interest purchased by the entity or the other owners on retirement.

Disability: The disability of an owner who has been active in the business may trigger a buy-out. The agreement must carefully define “disability” and provide the means for determining disability. It is fairly common for either the entity in a redemption agreement or the shareholder or members in a cross-purchase agreement to purchase disability buy-out insurance. Ordinarily, the buy-out is triggered after a specified period of continuous disability.

Expulsion or termination of employment: An employee-owner’s voluntary or involuntary termination of employment or expulsion from the business may trigger a buy-out. The reason for termination of employment may dictate the purchase price for the withdrawing owner’s interest or the term of payment.

Bankruptcy: A buy-sell may be triggered by an owner becoming insolvent as evidenced by the initiation of any proceeding under federal or state laws for the relief of debtors, including the filing of a voluntary or involuntary petition in bankruptcy; an adjudication of insolvency; an assignment of property for the benefit of creditors; the appointment of a receiver, trustee, or conservator for any substantial portion of the owner’s assets; or the seizure by a sheriff of any substantial portion of the owner’s assets.

Encumbrance: Whether the buy-out should be triggered by an encumbrance (e.g., a pledge) of shares is an important question that must be decided when the agreement is being drafted. Although many buy-sell agreements contain an outright prohibition on encumbering shares, this prohibition can prevent the shareholders from tapping a valuable source of credit before a real threat of default and foreclosure has materialized. Therefore, consideration should be given to permitting owners of interests to borrow against their shares, with a buy-out triggered only by a default on the encumbrance. For an encumbrance form clause in a corporate buy-sell agreement. California permits partners and LLC members to encumber or assign the economic attributes of their partnership or LLC membership interests. See Corp C §§15901.02(ak), 15907.011650217705.02. Those laws generally do not permit partners or LLC members to assign their entire partner or membership interests without consent of the other partners or members. See Corp C §§15907.021650317705.02.

Loss of license; death of licensee: Loss of a professional license by a shareholder or partner of a professional corporation or partnership usually triggers a mandatory buy-sell obligation to ensure continued compliance with professional corporation and licensing statutes. Similarly, the death of a licensee or any other triggering event that may result in transfer of an interest to an unlicensed party should trigger a mandatory buy-sell obligation. For example, a law partnership is prohibited from continuing to practice law if one of the partners ceases to be licensed to practice law. Cal Rules of Prof Cond 5.4(b). See also Le v Pham (2010) 180 CA4th 1201, in which the court held that 50 percent owners of shares in a pharmacy corporation breached their fiduciary duty to the other 50 percent owner by selling their shares in violation of the corporate bylaws, which contained a right-of-first-refusal provision. Sale and transfer of pharmacy corporation shares is strictly regulated by the state as a matter of public policy. See the Moscone-Knox Professional Corporation Act (Corp C §§1340013410). All changes of ownership of a pharmacy must be reported to the board within 30 days (16 Cal Code Regs §1709(a)), which was not done in this case, and the board may require a pharmacy to provide evidence that its owners or officers are knowledgeable in the laws governing pharmacies (16 Cal Code Regs §1774(a)(6)). As a pharmacy corporation shareholder, the defendant, despite her equal ownership interests, was vulnerable to the plaintiffs’ attempts to exercise control over the highly regulated corporation by transferring their shares in a manner that defied corporate, statutory, and regulatory obligations. The plaintiffs’ actions resulted in the temporary closure of the pharmacy, which damaged both the defendant and the corporation.

Attempt at dissolution: The agreement may also provide for buy-sell rights if the corporation is the subject of a voluntary (Corp C §1900) or an involuntary (Corp C §1800) dissolution attempt. Under Corp C §1800(a)(2), shareholders can file a complaint for involuntary dissolution if the complaining shareholders hold shares representing not less than one-third of the equity of the corporation under one of three alternative tests. See, e.g.Kline Hawkes Cal. SBIC, L.P. v Superior Court (2004) 117 CA4th 183.

NOTE:  The provisions of the buy-sell agreement may be superseded by the buy-out and valuation procedures of Corp C §2000 unless the articles provide that the buy-sell agreement governs. (Note that under a clarifying amendment of Corp C §2000 effective January 1, 2018, the articles need only reference the agreement; they do not need to provide the terms of the buy-out.) Corporations Code §2000 refers to “liquidation value as of the valuation date but taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation.” When there is no such possible sale, this language necessarily anticipates the piecemeal valuation of the corporation’s existing assets and liabilities as of the valuation date, without consideration of any winding-up period. See Trahan v Trahan (2002) 99 CA4th 62, 70.

Breach of agreement: A buy-out may be triggered by an owner’s attempt to sell, pledge, hypothecate, encumber, assign, or otherwise alienate his or her interest without compliance with the agreement.

Criminal conviction: An owner’s conviction of a misdemeanor or felony (often subject to certain limitations, e.g., misdemeanor involving moral turpitude).

Willful misconduct: An owner engaging in willful misconduct, fraudulent activity, conflict of interest, personal dishonesty, breach of fiduciary duty, or willful violation of law that, in any manner, adversely affects the entity’s business or reputation. For example, “willful misconduct” may be defined to include (1) the knowing and intentional failure to exercise ordinary care to prevent material injury to the entity or (2) an intentional act with knowledge that it is likely to result in material injury to the entity.

Incompetence: An owner being declared insane or incompetent, or being placed under the control of a guardian or conservator, by a court of competent jurisdiction.

Dissolution of marriage or domestic partnership: An owner’s dissolution of marriage or domestic partnership, if the parties live in a community property state where an interest in the business could be awarded on dissolution to a spouse or domestic partner who is not active in the business under the “equitable distribution” rules. In California, an agreement that provides that the purchase is triggered by any transfer of the interest could apply to a transfer in connection with a dissolution of marriage or domestic partnership. See Casaday v Modern Metal Spinning & Mfg. Co. (1961) 188 CA2d 728Fam C §§297.5299.

Making the buy-out optional rather than mandatory in any of the buy-sell events also should be considered

 Permitted Transfers

A buy-sell agreement usually provides for the transfer of an owner’s interest to certain permitted transferees without the consent of the other owners and without triggering an obligation or option to purchase the interest. Transfers generally may be made to

  • Other owners;
  • Immediate family members (normally of lineal descent), especially if they are active in the business;
  • A revocable trust established for the primary benefit of the owner and his or her spouse or registered domestic partner and issue, provided that the owner is the settlor and a trustee of the trust; or
  • Any general or limited partnership, corporation, limited liability company, cotenancy, joint tenancy, or other entity that the owner controls (however, this type of transfer is usually structured so that the transferred interest remains subject to the buy-sell agreement; .

Transfers will be restricted when they may violate statutes or regulations. For example, transfers of interests in S corporations will be restricted to eligible transferees. See IRC §1361.