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:

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:

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.

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:

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.

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.

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:

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.

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:

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.

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:

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

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:

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.

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.

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.

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.

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 make the repurchase optional instead of obligatory. That way, if there aren’t funds to complete the repurchase or if the financial responsibility of the repurchase is too burdensome on the company, then the company can opt-out of the repurchase right. This approach is part of the business-first philosophy that I advocate.

The second thing I do is give the company the option to pay the repurchase price either upfront or over time to avoid forcing the company to come up with a large lump sum all at once.

Third, if the business has the capital to do so, look into other alternatives to pay as much of the repurchase price upfront as possible. These alternatives include key-person insurance, SBA and bank loans, and sinking funds.

You should address these three components of the installment-payment structure in your operating agreement or shareholder agreement:

My default percentage for a small business is 10%, and the company pays the remainder over five years at 5% interest. Larger companies will reduce this percentage.

Another tip is to include an installment-payment provision as a fallback option even if you use one of the below alternatives.

Key person insurance can be either life insurance, disability insurance, or both, which the company purchases on the key owners. If a triggering event happens, the insurance is paid to the company. The company can use this insurance to fund the buy-sell repurchase price.

Like personal life insurance, key person policies can be purchased as term or whole life insurance policies and vary in price based on the key owner’s age and health.

Suppose you use key person insurance to help fund the buy-sell agreement. In that case, you will need to make sure that you pay attention to the increases in the value of your key owner’s equity to make sure that you have sufficient insurance available to pay the repurchase price.

As discussed above, this is a reason that we advise our clients to have the installment payments options available as a fallback option because this will function better with these key person policies.

If worse comes to worst or you want to fund the repurchase immediately, you can go to your bank or other private lender and get a loan to finance the repurchase price. There are various loan programs available for these kinds of purchases, each with different pros and cons.

You must consider that the lender will require you to give some kind of collateral for the loan. This collateral could be assets or equity in your company. In some circumstances, the lender may also ask for liens on your personal assets like your home, cars, and other valuable assets. Another common request from your lender will be a personal guaranty of likely all significant equity owners.

Granting collateral and personal guaranties can result in significant additional risk to your company and your personal finances. Proceed with caution!

A sinking fund is just a fancy way of saying that you will set aside a certain amount of money on a monthly, quarterly, or annual basis that will be used for paying the repurchase price of the buy-sell agreement. Setting up a sinking fund can be as easy as setting up a separate savings account. This money can also be invested in different liquid investments to safely increase your savings set aside to cover your buy-sell purchase price.

In conclusion, these are some of the common ways to cover a buy-sell agreement’s repurchase price. Remember, these are not exclusive, but you can use these strategies together to pay the repurchase obligations allowed in your operating agreement or shareholder agreement.

A provision that sometimes sneaks its way into operating agreements and buy-sell agreements is the shotgun provision.

The shotgun provision allows an owner to purchase equity from or sell their equity to their partner at an amount that they set. Then, the non-offering partner has to decide whether to buy his partner’s equity or sell his equity to his partner at that amount.

While this sounds innocent enough, I am not a fan. As a business lawyer, one of my jobs is to watch out for situations where parties can use contracts to take advantage of other parties. When people are taken advantage of, lawsuits happen, and lawsuits are what I get paid to help my clients avoid.

I have seen with this provision that owners can take advantage of the financial disparity between owners. Suppose one owner has significantly fewer financial resources than another. In that case, the financially weaker owner is at a significant disadvantage. The financially stronger owner may use this provision to force the financially more vulnerable partner out of the business even when that owner may not want out.

Another problematic situation arises when you have more than two owners. Trying to navigate this provision equitably between two owners is hard enough. Try doing it with five owners. It quickly becomes a mess.

As a corporate attorney trying to protect businesses’ interests over the owners’ interests, I also don’t like how owners who may provide a significant value to the company could be forced out of the business by this provision by an owner with differing opinions.

Beware the shotgun provision. There are just too many ways to abuse it.

A quick word of caution about buy-sell agreements; the buy-sell agreement doesn’t replace equity vesting. Having a buy-sell agreement in your operating agreement or shareholder agreement doesn’t replace properly using vesting. Vesting is a separate, critical way to control your cap table and equity. Buy-sell agreements do not protect the company from an equity owner who just stops providing your company services.

Most businesses are well served with a buy-sell agreement, but most are not all. Here are a couple of situations where buy-sell agreements may not make sense:

While there are many nuances to buy-sell agreements, every multi-owner small business should explore whether a buy-sell agreement makes sense for their operating agreement or shareholder agreement. If it makes sense to include one, make sure that you think about how to value the company’s equity and start planning how the company will pay that repurchase price. Ignoring those two items is a formula for buy-sell failure.

If you want some help getting this figured out for your business, don’t hesitate to contact one of Freeman Lovell’s business attorneys. We can help you.

Call or text us at (385) 217-5611 or send us a message through our Contact Form .

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