In the Sale of a Multi-Owner Business, a Buy-Sell Agreement can Save the Day

Preparing your co-owned business for sale should include provisions for responding to unexpected events in an owner’s life.

The $55 million sale of I.W. Savage Crushing LLC was three days from closing. The due diligence phase was over; the buyer’s down payment was in escrow; the lawyers were making final tweaks to the purchase agreement and promissory note; and the Savage brothers – Doug, Blake, and Curt – looked forward to the next chapters in their lives.

Then, suddenly, three days before the closing, Doug died.

And, almost as suddenly, the sale of the company was in legal limbo:

• Doug’s interest in the LLC was owned by him individually – i.e., not by him and his wife, and not by their revocable trust.
• Doug’s LLC interest was personal property, subject to probate.
• Doug’s wife stood to inherit his interest, but the ownership transfer would not occur in three days.
• The LLC’s governing documents made no provisions for the death of a member or for keeping a departed member’s ownership interest in-house.

The buyers were willing to be patient – to a point. But after the closing date was moved back for the third time, they backed out to pursue another opportunity.

This sad story could have had a less tragic ending. If the Savage brothers had devoted to their company’s governance just a fraction of the time and energy that went into maximizing its market value, the sale could have moved forward within an acceptable margin of delay.

Buy-Sell Agreement – in General

For any type of entity (LLC, partnership, or closely-held corporation) that has multiple owners, the financial and emotional pain that can occur in response to one of these “killer D’s” – death, disability, divorce, default, departure, disaster, or disagreement – can be avoided by a well-conceived buy-sell agreement.

“Of the more than 1,100 successful business sales that we have handled, we’ve seen more than a few situations where an eleventh-hour crisis involving one of the owners threatened the deal,” said IBG Business co-founder John Zayac, managing partner of IBG’s Colorado office. “Fortunately, in most cases the owners had made some provision, such as a buy-sell agreement or buying key-person life insurance, that covered the crisis and allowed the closing to occur, more or less on schedule.”

As Investopedia explains, a buy-sell agreement is a “legally binding contract that stipulates how a partner’s share of a business may be reassigned if that partner dies or otherwise leaves the business. Most often, the agreement stipulates that the available share be sold to the remaining partners or to the partnership.”

With a buy-sell agreement, the owners can agree, in advance:

• how an ownership interest would be transitioned in case an owner dies, gets a divorce, wants to retire, etc.;
• under what “triggering events” an owner would be bought out;
• how the interest of a departing owner would be valued;
• how the entity would fund the buy-out of an owner’s interest;
• what the process would be for removing an owner; and
• how to preserve, in a variety of circumstances, continuity of business operations.

Benefits. A buy-sell agreement offers at least four major benefits, as described in this Wolters Kluwer article:

• Business continuity: In the event of death, retirement, or incapacity, you can ensure the seamless continuation of your business.
• Compensation: Any survivor or designated successor will be properly compensated for the deceased owner’s interest.
• Assurance: Remaining owners can be sure that the deceased’s business share is not passed onto someone deemed unsuitable.
• Asset protection: If a triggering event occurs, the agreement creates a source of funding and liquidity and mitigates the need to sell assets.

To this list we would add “preservation of a business sale.”

Forms of agreement. A buy-sell usually takes one of three forms:

• A cross-purchase agreement allows the other owners to purchase the interest of an owner who dies, is disabled, or retires.
• An entity-purchase or redemption agreement calls for the business entity itself – not the other owners personally – to purchase an owner’s interest.
• A hybrid of the first two types gives the entity first right of refusal to purchase the departing owner’s interest before that opportunity is presented to the individual owners.

Shotgun clause. “We have seen cases where, while a deal was in process, a disagreement between two co-sellers threatened the closing,” recalls IBG managing partner Robert Latham (Texas). “With time running short and the deal on the line, they invoked the ‘shotgun clause’ in their buy-sell.”

A shotgun clause is something of a nuclear option, in which owner #1 offers to buy out, at a specified price, the interest of owner #2, who can either accept the offer or buy out owner #1 at that price.

Where a sale is pending, that leaves one owner to bargain with the buyer.

Valuation. As was mentioned above, a buy-sell agreement can specify how an owner’s interests are to be valued for purchase. A few of the more common valuation methods include:

• pre-determined fixed price;
• valuation using a formula based on earnings or book value; or
• third-party valuation performed by a credentialed business valuation professional.

Funding the purchase. After an owner’s interest is valued, the purchase of that interest can proceed. The buy-sell agreement should specify how the purchase is to be funded. Common funding methods include these and may vary with the nature of the triggering event:

• Cash buyout
• Installment payments
• Percentage-of-earnings payments
• Life insurance
• Disability insurance

Do It Now

Would a buy-sell agreement have saved the sale of Doug Savage’s company? Probably. The closing might have been held up, but the sellers would have been in a better position to show the buyers a path to a closing with manageable, relatively minor delays.

In all likelihood, in leading the Savages through the buy-sell agreement process, their business attorney or accountant would have recommended at least the following:

• estate-planning changes in how the brothers held their ownership shares;
• including in the company’s governing documents a provision for how, in response to various triggering events, one owner’s interest would be transferred to the entity or the other owners; and
• a funding mechanism (e.g., life insurance) for buying out the interest of a deceased owner.

Attributed as an old Chinese proverb is this bit of wisdom: “The best time to plant a tree was thirty years ago. The second-best time is today.”

To have value, a buy-sell agreement must be adopted as early as possible, while relationships among the owners are relatively positive, and before a triggering event has occurred, so that preparatory steps can be accomplished in a timely fashion.

Your business attorney can lead you through the process of identifying issues and making good decisions. Initiate that process now, before a death, divorce, etc., can threaten the value of your business.

For assistance in evaluating the readiness of your business to be offered for sale, contact an IBG Business M&A professional near you.