Buy-Sell Agreements Prevent Disruptive Changes of Ownership | Part 1

If a business entity has multiple owners and those owners are interested in preventing or minimizing disruptions that arise when interests (or shares) of the entity are transferred, then they need to invest in a buy-sell agreement.  Whether the transfer arises voluntarily or involuntarily, a well-drafted buy-sell agreement can alleviate uncertainty, surprises and possible litigation between and among the company and its owners.

This article is the first in a two part series. This first article series focuses on voluntary transfers of ownership interests.  The second article will address involuntary transfers in the context of death, permanent disability, termination of marriage, and termination of employment.

What is a Buy-Sell Agreement

A buy-sell agreement is an agreement among the business entity (corporation, limited liability company, etc.) and its owners that specifically addresses voluntary and involuntary transfers of ownership.  It sets a predetermined road map that springs into effect when certain conditions are met or events occur.

Typically, these conditions or events include (i) the voluntary transfer of ownership interests to a third party and (ii) the death, permanent disability, divorce or termination of employment of one of the owners that could result in or trigger an involuntary transfer of ownership interests.  What should happen to the ownership interests in these situations should reflect each company’s unique ownership structure, development timeline, and the needs and circumstances of the owners and their families.     

Ownership Interests and Restrictions

The governing documents of a company typically will restrict any sort of transfer of ownership interests without the consent or approval of the other owners and/or the company.  If that is not the case, then transfers can be made freely (subject to certain federal and state securities law requirements not discussed here).  Not having this restriction allows one owner to sell or transfer its ownership interests to any third party without any say-so from the other owners or the company.    

If there is a restriction on transfers, then an owner will need to seek such approval before effecting the transfer.  However, this approach can be cumbersome, and from the transferring owner’s perspective, can create concern that consent may not be granted at all.  Sometimes, an owner will want some sort of mechanism to be able to exit from the company.  But from the other owners’ and company’s perspective, they want to be able to control who becomes a new owner.  Imagine the surprise of waking up one day and finding out that one of the owners has transferred its ownership interests to a competitor or to someone who has an undesirable reputation or doesn’t know anything about the company’s business.     

Two typical concepts that can address the concerns of all parties in the voluntary transfer context are the right of first refusal (ROFR) and the permitted transfers.  

Right of First Refusal

The ROFR is intended to allow an owner to sell its ownership interests to a third party if the other owners and the company do not purchase all (or some predetermined portion) of the ownership interests.  Under the typical ROFR, an owner seeks a buyer and negotiates the terms of sale of the ownership interests.  After the negotiated terms are finalized, the owner then is required to offer to the company and other owners the right to purchase the interests based on the negotiated terms.  The company and other owners have a certain period of time to elect to purchase based on those negotiated terms or pass on the opportunity.  If they pass, fail to elect to purchase or fail to close the purchase, then the owner can proceed with the sale to the third party; and if the sale to the third party doesn’t occur or if the negotiated terms change in a material way, then the offer process starts over again.  

Some key features to consider under the ROFR:

1.     It allows the transferring owner a way to exit the company and the other owners and the company to prevent unwanted buyers to become an owner of the business.  However, for the owner desiring to transfer, it may be difficult to find a buyer to purchase the minority ownership interests of a private company, especially if the buyer will not have much control over the business, operations, and timing of cash flow distributions of the company.  For the other owners and the company, if they want to prevent the third party from becoming an owner of the business, they will have to purchase the ownership interests on the same terms that were negotiated between the selling owner and the third party buyer.  Those terms may not be desirable (such as the valuation is too high) or may not be performable (such as full payment of the purchase price at closing, which means the other owners and the company will have to come up with the funds by the closing date).

2.     Establish reasonable time periods for events to occur.  The ROFR will have specific time periods for (i) the other owners and the company to elect to purchase the shares being offered for sale, (ii) the closing between the selling owner and the other owners and the company to occur, and (iii) if the other owners and the company elect not to make or fail to make an election to purchase the shares, the closing between the selling owner and the third party to occur.       

3.     An ever green provision (or intentional lack of one) that states that an election not to purchase or a failure to elect to purchase the shares is not a waiver of the ROFR in future situations.  For example, if the closing between the selling owner and the third party doesn’t occur, then the next time the selling owner finds a new third party buyer, the selling owner should go through the ROFR process again.

4.     A material change provision that states that if the terms of the transaction with the third party changes materially from when it was offered to the other owners and the company, then the selling owner must re-offer those changed terms and conditions to the other owners and the company.  This provision eliminates the possibility that the terms may be changed later to be more favorable to the third party and the other owners and the company are denied the benefit of the more favorable terms.

Permitted Transfers

Just as the phrase implies, permitted transfer provisions allow an owner to transfer its ownership without being subject to the consent or other voluntary transfer restrictions.  Although permitted transfer provisions can by varied, they usually contemplate a transfer in which the original owner retains some sort of control over the shares being transferred.  Transfers for estate planning purposes is an example.  Owners may want to put ownership of the shares in a trust, family limited partnership, or other estate planning vehicle in which they retain control over the shares either as the trust trustee or as the general partner of the limited partnership.  Alternatively, owners may want to gift (or transfer) the shares to family members.  

Similarly owners may want to restructure how they hold shares of a company, and thus move the ownership of those shares from a personal holding into a limited liability company, corporation or other entity.  These entities are usually established and controlled by the owner.  

All of these transfer circumstances are conducive to allow the original owner to retain control over the shares.  That is the key to permitted transfers.  There are usually conditions that the transferring owner (i) retain control over the shares (i.e., the voting of those shares), (ii) notify the company of such transfer, and (iii) ensure that the same terms, conditions and restrictions of ownership applicable to the transferring owner are imposed on the transferee.  It is important to impose these conditions in permitted transfers to ensure that the original owner, who the other shareholders and company know and originally agreed to enter into business with, continues to be the primary point of contact with the company.

Conclusion

Owners of businesses should give serious thought to these voluntary transfer issues.  They may decide that a blanket restriction on transfer is appropriate such that any transfer would require the approval of the company and/or the other owners.  However, this approach exposes the minority owners to the whims of the majority owners.  Not having a restriction on transfer at all exposes the other owners and the company to an unwanted partner.  Properly drafted and thoughtful voluntary transfer provisions can address these issues.  

In my next article in this series, I’ll address the key considerations for involuntary transfers that protect both the company and ensure equitable treatment of the departing owner.  Business owners should give serious consideration to voluntary transfer issues and seek the advice of experienced counsel to discuss their specific situation.

About the Author:

Tri Nguyen has served as general counsel and company lawyer to businesses, executives, startups and entrepreneurs for over 18 years.  He particularly enjoys helping companies grow and achieve their strategic plan, and believes that every business needs a Chief Legal Advisor.  He can be reached at www.trilawoffice.com.