Business partners set up shop with the best of intentions. It’s a relationship that must be built on mutual trust and respect. But no matter how strong a personal or professional relationship is at the outset, shareholder conflicts and other events may occur that can affect the continuity of the business operations. A mechanism and process that establishes the ground rules for the orderly transfer of the businesses shares caused by unforeseen conflicts or events is important. A suitable buy/sell clause in the shareholder agreement that is understood by the parties is an important tool to ensure this orderly transfer and the continuity of the business operations.
A buy/sell clause is often the most neglected feature of a shareholder agreement, either because it’s set forth in an arbitrary and confusing manner, or because it’s neglected altogether. It can be an uncomfortable subject to raise when fellow shareholders are close friends or family, since it‘s analogous to asking a fiancé to sign a pre-nuptial agreement. However, the lack of a buy/sell clause often results in disputes, costly legal proceedings, long delays in transferring of ownership and disruption in the business operations.
The buy/sell clause provides a mechanism for how and when the remaining shareholders can purchase a departing shareholder’s shares due to a triggering event, such as a shareholder retirement, disability, death or dispute. It also defines how that purchase will be funded to ensure liquidity. Funding is often accomplished through a life insurance policy.
Most importantly, it forces shareholders to agree on the method that will be used to determine the purchase price of the shares Here are some examples of methods used to determine price in a buy/sell agreement:
- Price is determined by a business valuator.
- The parties to the agreement negotiate a fixed price and update annually.
- The price is determined by a formula.
- Price is determined by a shotgun clause.
- Price is determined by the right of first refusal.
Each of the methods has its advantages and disadvantages. To determine which is in the best interests of all shareholders, a business valuator should be consulted during the drafting of the buy/sell clause.
In my next two posts, I’ll feature two case studies that put this in perspective.
The first will explore the legal nightmare that arose in a business when a majority of shareholders wanted to force the rest to accept a buyout offer, without the guidance of a buy/sell clause. The second will examine a business that did it right from the outset, and how this ultimately played out to the benefit of all shareholders.