Buy Out Clauses: 3 Key Considerations for Business Owners

Drafting a strong buy out clause, also referred to as buy-sell agreements, is a small preventative measure that can pay serious dividends in the long-run.  Many companies are structured so that ownership isn’t characterized by one sole proprietor, but rather a group of partners, members, or shareholders.  The benefits of these types of partnership-driven structures are plenty.  However, for even the most cordial of business relationships, the buying/selling of ownership shares among partners can get complicated, emotionally-charged, and legally drawn-out. 

In general, it’s strongly advised to formally establish ground-rules for restructuring ownership among business partners.  Without predetermined procedures, the transfer of high-value ownership is near-impossible.  Here’s where the buy-sell agreement can help.

A buy-sell agreement—sometimes called a buyout agreement, a business continuation agreement, or a business will—is a legally-binding document that establishes the terms and procedures regarding a partner’s departure and the buying/selling of their company shares.  As with any legally-binding document, it is important that the buy-sell agreement is written with clarity, concision, and (preferably) with a lawyer’s expertise.  

Importantly, the ultimate goal of a buy-sell is to produce a fair and predictable outcome that protects the business, the departing individual, and the remaining owners.  Unfortunately however, many companies opt not to establish buy-sell agreements or buy-out provisions.  Further, buy-sell contracts that are ambiguous or incomplete can actually do more harm than good, ultimately leading to stalemated disputes or even litigation.   

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Three Key Considerations for Your Buy-Out/Buy-Sell

Most owners should consult an attorney or other professional for assistance with their buy-sell.  Even the most experienced of businessmen might have difficulty drafting an unbiased contract that garners support from each of the other partners.  Nonetheless, here are three tips that all businesses should consider when it comes to buy-sell agreements:

1. Include the Standard Sections and Refrain from Ambiguity

Most buy-sell agreements are broken-up into three sections.  These parts should be clearly defined and concisely-written: 

  • “trigger” events that facilitate the buy-out process
  • language regarding who is able to buy/sell shares 
  • the price that shares will be sold at

As we briefly mentioned earlier, shares of a company are rarely available for purchase.  Only under certain circumstances do company shares get transferred among owners or external entities.  These situations are commonly called “trigger” events, and they should be clearly specified in the buy-sell agreement.  Perhaps the most common event that “triggers” the buy-out process is the death of a partner, but other events might include retirement, resignation, divorce, criminal convection, or bankruptcy.  Once the trigger event occurs, only specific individuals or entities can buy the newly-available shares (in accordance to the terms of the buy-sell).  Finally, the agreement should establish the price at which the newly-available shares will be sold.  This can be done using a formula or a hard-number, so long as the valuation was done mindfully.  In each of the three sections—trigger events, applicable buyers, and valuation methods—ambiguous language can inject uncertainty into the agreement, and ultimately lead to emotionally-tense debates or litigation.

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2. Draft Early, Review Regularly

The importance of drafting the buy-sell agreement early in the company-formation process cannot be overstated.  Too many companies find themselves in the difficult position of trying to hash-out important restructuring decisions after-the-fact of a trigger event.  In these situations, coming to any satisfactory conclusion is compounded by the fact that every partner has an immediate and direct stake in the outcome of the buy-sell terms and conditions.  For this reason, the agreement should be drafted early in the process—in-fact, some professionals suggest including buy-sell provisions within the company’s most fundamental contracts, such as the partnership agreement or operating agreement.  Additionally, the buy-sell should be reviewed on a regular-basis.  In short, companies evolve over time and outdated contracts often result in stalemated disputes and dissatisfied partners.

3. Carefully Consider various Valuation Methods

The challenge of choosing a valuation method to aptly valuate your company is non-trivial to say the least.  Perhaps surprisingly, there are many ways to place a “price-tag” on a company, and this price can fluctuate significantly depending on the valuation method employed.  For this reason, owners are encouraged to treat the challenge of valuation as a context-specific problem.  In other words, they should survey various valuation methods (such as market-based approaches, asset valuations, profit-based approaches, etc.) and chose the one that best fits their business and particular situation.  

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The Bottom-Line

Arguably more important than any of these three tips, business owners that are serious about protecting their company, their fellow partners, and their personal assets should consult an experienced professional to help with their buy-sell agreement.  If buy-sell provisions are non-existent, a business attorney can help draft agreeable terms and conditions.  Likewise, if a business has a working buy-sell, it should be reviewed and/or updated.  

Weak agreements can often-times do more harm than good by further obfuscating ownership rights.  A solid contract will include specific language on trigger events, applicable buyers/sellers, and share prices.   Furthermore, the challenge of determining a fair and agreeable business valuation method is non-trivial.  In most cases, a professional should be consulted to ensure that the agreement is clear, current, resilient, and fair.

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