AUTHOR: Rick Evans - CPA, CA, CFF, ABV, CVA, CFE, CPA (CALIFORNIA)
Business partners set up shop with the best of intentions. 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 buy/sell clause in the shareholder agreement that is understood by all the parties is an important tool that provides a mechanism and process to ensure an orderly transfer and the continuity of the business operations.
The importance of a Buy/Sell Clause
A buy/sell clause is often the most neglected feature of a shareholder agreement, either because it has been set forth in an arbitrary and confusing manner, or because it has been neglected altogether. It can be an uncomfortable subject to raise when 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.
A 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.
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.
I’ve seen a lot of unfortunate situations in my professional career such as—shareholders who pass away, become ill, endure a personal crises that derails their business focus, or simply fail to fulfill their obligations to their business partners. Without a well-written buy/sell clause, any of these scenarios can cause undue hardship and financial loss for all of the stakeholders of the business.
Death of a Shareholder
Take Howard, for example. He is a 40% owner of an electrical contractor. Three other shareholders each hold 20 per cent.
Howard and his wife have three children. His wife doesn’t work and depends on the income generated from Howard’s ownership interest in the company.
Then Howard dies, without a buy/sell clause in the shareholder agreement. This leaves his wife with his 40 per cent ownership interest in the company, but she has no intention of actively participating in the operations of the company. She needs the proceeds from the sale of Howard’s 40 per cent interest to provide for herself and her children.
The other shareholders don’t want an unknown party acquiring Howard’s shares, but they do not have the funds available to buy Howard’s interest. They also have the added challenge of finding someone with Howard’s expertise to take over his role with the company.
Fifty per cent of the company’s revenue comes from a single general contractor. Seeing how uncertain the future of the company has become, this general contractor is considering taking its business elsewhere.
Without this customer, the company’s value could plummet. Employees could be terminated. The potential loss of value may result in Howard’s wife having to sell her shares for a fraction of what they were worth when Howard was alive.
How much value will Howard’s wife lose? How will this impact her ability to provide for herself and her children?
Now, if there had been a proper buy/sell agreement, it would have:
- Provided a mechanism for how and when the remaining shareholders could purchase Howard’s shares.
- Defined how the other shareholders could have funded a purchase of Howard’s shares to ensure liquidity for his wife. Funding is often accomplished through a life insurance policy.
- Ensured the shareholders would have agreed on the method that would be used to determine the purchase price of the shares.
For more information on buy/sell agreements, please contact your McCay Duff advisor.