Buy-sell agreements are important to have for any LLC that has more than one owner or member. While most companies that form new businesses will draft an operating agreement, that document only covers issues like the following:
Who makes what type of decisions
What is the degree of consensus needed for various types of decisions (e.g., majority, unanimous, etc.)
What happens if the company needs more money (either a as a loan or capital contribution)?
How does the business decide the right timing and amount of distributions?
What happens if the company has to shut down?
What an operating agreement typically doesn’t cover is what happens when someone wants or needs to leave the company. People leave companies for all sorts of reasons – new business opportunities, disagreements within the company, and more unpredictable reasons such as death or disability.
If there isn’t a document that controls the exit process, the parties involved often have different ideas about what that process (and ultimately payment) should look like. And when parties disagree about what happens when one of the owner needs to leave the company, relationships usually get messy.
There are four key components that your buy-sell agreement should cover:
1. Who has the ability to purchase
If someone wants to leave, generally the company has the first right to purchase their shares.
The reasoning here is that when multiple people start a company with one another, they usually don’t contemplate one of the founders leaving and being replaced with a stranger.
2. What events would result in an automatic buy-sell?
Some common automatic events might be a bankruptcy that puts the company’s assets at risk, or if someone commits an act of fraud while working for the company.
Other automatic buy-sell events might include death, disability, or forced retirement.
3. The valuation of the company
What is the company worth and how much is the leaving member’s share of the company worth?
This can be determined in a couple ways. You could hire a third party to appraise the business or you could insert your own formula into the agreement. Either way, the goal is to make sure people on both sides of the transaction feel like the sales price is fair.
4. Payout schedule
Often there is a small upfront payment, followed by a schedule of payments over a period of years. This allows the leaving member to be compensated in full, and also ensures that the company can continue to effectively do business.
Timing is important. It’s important to discuss buy-sell agreements when things are new and everyone still gets along great. Once meaningful money gets involved, these discussions get exponentially more difficult. Unfortunately, It can be a lot harder and more expensive to come to an agreement when things go sour.