(Un)Common Sense Lawyer: Portland, Oregon Small Business Law Blog

What are buy-sell agreements?

Buy-sell agreements may be the most important documents Oregon small business owners create upon forming a new company.  I’ll let that sink in for a moment… Buy-sell agreementss are contracts between business owners that spell out the rights each owner to transfer his interest in the business.  Buy-sell agreements generally come in three flavors:

1. Redemption Agreements.  Agreements where the company has the option or obligation to purchase an owner’s interest in the company upon the occurrence of certain triggering events (e.g. retirement, death, disability, or divorce).
2. Cross-Purchase Agreements.  Agreements where each owner has the right or obligation to purchase another owner’s interest upon certain triggering events.
3. Hybrid Agreements. Agreements that contain some combination of redemption and cross-purchase terms.

Why you want need a buy-sell agreement to for your closely held Oregon business

Buy-sell agreements are particularly important in small and closely held businesses because they provide answers to questions that you’re not asking at the beginning of a business venture, but almost certainly will have to ask at some point down the road, such as:

1. When can an owner transfer his interest in the company?
2. Who can an owner transfer his interest in the company to?
3. How is an owner’s interest in the company valued?

Buy-sell basics

Give the company and remaining owners the option to buy back remaining shares: the right of first refusal. The backbone of most buy-sells is the right of first refusal.  When one owner wants to sell, the agreement provides that the company or other owners have the right to purchase the selling owner’s interest before any other buyer.  So if your Oregon LLC has three members, and Member A wants to sell his interest in the company to Buyer for $25,000, Member B and Member C have the right to purchase Member A’s interest at $25,000 first.

Ownership transfers can be disruptive, so limit them. By their very nature, small businesses are, well, small.  They’re owned and operated by a select few, usually friends, family, or longtime business partners.  Bringing in unknown third parties to the delicate ownership ecosystem of a small business can be disruptive.  A well-drafted buy-sell agreement between the owners of an LLC or other small business entity can define when a business owner may sell his interest and to whom he may sell it to, which limits surprises and the potential for deadlock.  Buy-sells can also limit transfers between owners to preserve each original owner’s proportionate ownership.

You don’t need to limit all transfers, just some of them. For practical and legal reasons (read: you probably can’t do it anyway), a buy-sell needn’t forbid all transfers of ownership in a company. Buy-sells routinely define a class of transferee whom an owner may sell to without restriction.  This type of agreement preserves unrestricted transfer rights to a limited group of potential buyers such as certain family members in a family owned business. And all buy-sell agreements allow an owner to sell to another party if the remaining business owners consent.

Clearly define the events that trigger buy-sell agreement terms.  This is the meat and potatoes of the buy-sell agreement.  Owners need to know when/if a buy-sell provision applies, so be specific.  Both voluntary and involuntary transfers can be triggering events.  Transfers can be sales, gifts, exchanges, contributions, devises, ledges, bankruptcy transfers, divorce settlements, foreclosures, or anything else that would cause a change in the current ownership percentage.  Draft accordingly.

Name your price and payment terms. If you’ve never tried, valuing a small business can be exceedingly difficult, so don’t punt on this one.  An otherwise good buy-sell can fall apart if price and payment terms aren’t defined properly.  It’s great to to know who can buy out whom, but if you don’t know at what price and when payment must be tendered, you don’t really have an agreement at all.  There’s no right answer to this, but common methods are:

1. State a definite value of the business in the buy-sell.  This provides certainty at the outset, but owners must be mindful to revisit and reevaluate the buy-sell price as the business grows and changes.
2. Leave the price to be agreed upon later.  Simple, yes, but also dangerous.  With no set price or formula there is much uncertainty when triggering events occur.
3. Base the price on a bona fide offer.  This works well in a right of first refusal situation.
4. Create a formula.  Assuming the company’s owners have a sophisticated understanding of how to value their business, a formula is fair, predictable, and automatically accounts for changes in the business.  On the other hand, creating the formula itself can be difficult during the infancy of a business.
5. Use an appraisal value.  This method is fair and impartial, but costly and time-consuming.
6. My personal favorite: the shotgun price.  Under this arrangement, one party names a price and the other party has a right to buy or sell at that price.  This keeps everyone honest, but it also has practical limitations when one party has limited financial resources compared to the other.

Of course, buyout provisions need payment terms, too.  Few small businesses will be able to afford to buy back half of its interest in cash on the spot.  That type of liquidity means business is doing very well.  Owners need to be very cognizant of their ability to purchase the interests of other owners and to be specific about the payment terms they are willing to accept.  In some cases, this may mean the business must take out a line of credit to repurchase an outgoing member’s interests.