Buy-Sell Basics


At Freeman Lovell, our business lawyers help entrepreneurs and small business owners not only avoid the legal pitfalls that can cripple their businesses but build scalable businesses and provide a successful exit for that owner.


Most multi-owner businesses need a buy-sell agreement in their LLC’s operating agreement or corporation’s shareholder agreement. The buy-sell agreement determines what happens to business owners’ equity in everyday situations like the death, disability, divorce, or bankruptcy of an owner.


This article will discuss the following topics:

  1. The importance of a solid foundation for your LLC or corporation;

  2. How a buy-sell agreement helps you control your cap table;

  3. The standard provisions for your buy-sell agreement;

  4. Common ways to value your business when a repurchase event arises;

  5. How to afford the repurchase price;

  6. What a shotgun provision is and why they are problematic; and

  7. Why a buy-sell agreement doesn’t replace vesting.


Importance of a Solid Foundation

A solid legal foundation is one of the essential keys to having a viable and sellable business, specifically how you choose to resolve the following issues:

  1. What kind of entity you choose;

  2. How you choose to be taxed;

  3. How you control your cap table;

  4. How and who makes decisions on behalf of your business.

Most fatal flaws that kill businesses happen because foundation cracks are left ignored until it is too late to fix them. However, you can avoid many of these problems if you catch them early on in your business journey.

Your LLC’s operating agreement or corporation’s bylaws and shareholders’ agreement will cover most of these issues. That is why those agreements must be written well and regularly reviewed.

Control Your Cap Table

One of the critical components of creating a solid foundation for your business is ensuring that it controls equity ownership. Controlling your cap table is important because, as your business grows, you will likely compensate key employees and partners with equity to attract the best talent and partners.


Making sure that you don’t have deadweight equity holders owning chunks of your business can be very important to do this right. The key ways that an LLC or corporation does this is through equity vesting and equity repurchase rights.


Our last article focused on vesting, and this article will focus on those repurchase rights that fall under the label of a buy-sell agreement. The events that trigger a company’s repurchase rights in a standard buy-sell provision are the following:

  1. The death of an owner;

  2. The long-term disability of an owner;

  3. The bankruptcy of an owner; and

  4. The divorce of an owner.

There are other repurchase rights that you should include in your operating agreement or shareholder agreement, like “for-cause” repurchase rights and others. For now, we’re going to focus on the buy-sell standard repurchase rights and how to structure and navigate those.


The Standard Buy-Sell Provisions

Our last article focused on vesting, and this article will focus on those repurchase rights that fall under the label of a buy-sell agreement. There are a few events that trigger a company’s repurchase rights in a standard buy-sell provision.


Death & Disability

Do you want the company to have the option to repurchase the equity of a deceased or disabled partner, or do you want to allow their heirs and estate to inherit the equity? These are critical questions to ask when considering this provision for your buy-sell agreement.


Here are the simplified mechanics of how this provision works:

  1. A partner dies (morbid, I know) or becomes disabled (as determined by a physician);

  2. Then the Company has a period of time (usually somewhere between 30 and 90 days) to let the partner’s estate or guardian know if they are going to purchase the equity;

  3. Then if the Company elects to purchase the equity, the company leadership and the estate try to agree on a value for the equity;

  4. If they can’t agree, then a valuation of the equity is completed; and

  5. Once the valuation is complete, there is another period of time for the company to pay the purchase price to the partner’s estate or guardian. We will discuss the options and alternatives on how the company can deliver this purchase price.

In some versions of this provision, the other partners can also purchase the deceased partner’s equity if the company decides not to buy back the equity.


In general, I like to see companies keep their options open and put their rights before the owners’ rights. With this in mind, my preferred approach is to give the company the right to purchase the equity at that time. Until then, you won’t know the company’s needs for additional equity or how great or difficult it may be to work with the deceased partner’s heirs.


Don’t worry; you won’t be taking advantage of them. The company will still have to pay the estate for the full fair market value.


Divorce & Bankruptcy

When a partner (or that partner’s spouse) files for divorce or bankruptcy, the divorce or bankruptcy court can take actions that could lead to having new and unwanted partners. In a divorce, this would be the partner’s ex-spouse. In bankruptcy, this would be the bankruptcy estate trustee. Either way, the business loses control of the cap table.


So how does this provision help?


First, this provision is triggered upon a court’s order or law that changes the ownership. So if your partner can navigate the divorce or bankruptcy in such a way that the ownership of his or her equity in the business doesn’t change, then this clause is never triggered, and that partner continues to own all of their equity.


So what happens if the court does transfer the ownership of your partner’s equity?


Here are the simplified mechanics of how this provision works:

  1. The court’s transfer of all or part of the partner’s equity triggers the repurchase right;

  2. Then the company has a period of time (usually somewhere between 30 and 90 days) to let the partner and the new owner know if they are going to purchase the equity;

  3. Then, if the company elects to purchase the equity, the company leadership and the new owner try to agree on a value for the equity;

  4. If they can’t agree, then a valuation of the equity is completed; and

  5. Once the valuation is complete, there is another period of time for the company to pay the purchase price to the new owner.

In some variations of this provision, the partner has the first right to buy back their ex-spouse’s equity.


Another critical aspect of making this provision binding is to have each partner’s spouse sign a spousal consent to the divorce and bankruptcy repurchase right.


Common Ways to Value a Business for Repurchase

So you added a buy-sell agreement to your operating agreement or shareholders agreement. The next step is to decide how to set the purchase price if an equity repurchase gets triggered. This section will explore the four most common valuation approaches that I see in my practice as a business lawyer. They are the following:

  1. A formal business valuation;

  2. An annual determination by the managers or directors;

  3. A multiple of EBITDA; and

  4. Book value.

These goals will help you determine which of the above options you choose:

  1. Accuracy

  2. Business Owner Effort

  3. Cost

  4. Time

  5. Simplicity

Business Valuation

With a business valuation, it’s as easy as hiring a business valuation expert to prepare a business valuation. To complete their report, the valuator will do the following:

  1. evaluate your financials,

  2. determine reasonable financial metrics and multiples to apply to your business,

  3. value your assets,

  4. analyze your intellectual property and business goodwill, and

  5. apply discounts for non-controlling equity holdings.

The not-so-easy part is getting all this information about your business. Business valuations can take months to complete and cost you thousands of dollars or more, depending on your business’s size and the complexity of its structure.


The upside of using a business valuation to determine the purchase price for your buy-sell agreement is that it is the most objective and accurate method to set a purchase price if a triggering event occurs. Another upside is that the valuation is determined by an independent third-party. The downside is that it is intensive in terms of business owner effort, time, and cost.


If the accuracy of the purchase price is the most crucial consideration, then going with a formal business valuation is the way to go.


Annual Determination of Company

This approach to valuing the company is the least scientific. With this valuation approach, the company’s owners and managers get together once a year and set the repurchase price for the coming year. Typically this happens in conjunction with an annual meeting at the end of a fiscal year. When done right, the owners consider some of the factors that a business valuation expert would consider, as discussed in the previous section. Ultimately, this is something that the company’s ownership and management determine.


This valuation approach works well when each of the owners fully engages in the company and understands the business well.


As a business attorney, I have concerns about this approach. When you have a larger group of owners who don’t have much experience with the company’s operations, this valuation approach can lead to legal disputes over whether the company’s management or ownership manipulated the valuation.


Another problem that arises with this approach is if the Company forgets to set the valuation in any given year or can’t reach a consensus on setting the purchase price. If that happens, there needs to be a different fallback method of valuing the company and establishing the buy-sell purchase price.


Multiple of EBITDA

EBITDA is a way to measure profitability without adjustments for non-operating expenses associated with interest, taxes, depreciation, and amortization. EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. Here is the formula for calculating EBITDA:


EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization


The “multiple-of-EBITDA” valuation approach is popular with technology companies because a multiple on EBITDA is a common way to value tech companies and negotiate investment valuations. For this reason, it is usually at the top of the mind of a founder seeking investors.


After calculating EBITDA, the next step is to understand what multiple to apply to your company. Multiples depend on business size, industry, location, and several other factors. Multiples for small to mid-sized private businesses typically range between 1.5x and 10x. Talk to a business valuation expert or business broker to get a feel for what the going multiples are for your business type.


Once you do the legwork to make sure that you can easily account for your EBITDA and set an appropriate multiplier, you will be ready to go. If a repurchase event triggers the repurchase of equity, you can take a look at your books, do a little math, and voila, you have your purchase price.


While this is super easy, the challenge arises when you are in a fast-growing business. A company that goes from $500K EBITDA to $1.5M EBITDA could quickly jump from a 2x multiple to a 5x multiple. Planning for this and building a range table into your valuation mechanism is essential, or it requires regular review and updating.


As a business lawyer watching my clients’ behavior, I have observed that most business owners don’t regularly review and revisit these things because they are not at the forefront of growing and building a business. If you go this route, take growth into account on increasing multiples or regularly review your operating agreement and shareholders agreement as a company. To share some practical advice, our law firm’s board of managers review and provide feedback on our operating agreement annually.


So while this is potentially an easy and convenient way to set a repurchase price, it comes with some accuracy perils that you will need to carefully monitor.


Book Value

One of the most straightforward ways that some companies choose to have their repurchase price value available is to have the repurchase price based on its book value. The book value is the value kept on the company’s internal books and accounting. The advantage to this approach is that it is effortless to establish, assuming that you are keeping up on your accounting. The disadvantage of this is that a company’s book value is often significantly less than its fair market value.


As a corporate attorney, I regularly advise against this for my clients, but on occasion, a client will insist, and if they are on top of their accounting and understand the risks, I will oblige.


How to Afford the Repurchase Price

The most crucial component of a buy-sell agreement is how your company is going to afford it. If you don’t plan to afford the purchase price, you can put your company in a deep financial hole if a repurchase right is triggered.


As a business lawyer, I prefer to