Does Your Silicon Valley Business Need a Buy-Sell Agreement?

When a new business is formed, there are high hopes and great expectations about the future. At the time of formation, the owners of the business are typically on the same page. Over time, however, the business evolves and circumstances may arise in which one (or more) of the owners wants to sell. To prepare for such scenarios, a buy-sell agreement should be put in place as soon as possible.

What is a Buy-Sell Agreement?

It is important to understand that a buy-sell agreement (also referred to as a business buyout agreement) has little to do with the sale or purchase of a business. Rather, it is a binding contract between the co-owners that determines when an owner can sell his/her interests, how a right-of-first refusal in the corporation and the other shareholders is structured, who is allowed to buy into the company if shares are sold, how the sale price will be determined, and other specific terms and conditions of the sale. Every Bay Area business with more than one owner should have a buy-sell agreement from its inception, because it helps protect the interests of each owner. Without a buy-sell agreement in place, stock is freely transferable by any shareholder, which means you could end up being co-owners of a business with someone you have never met and do not get along with.

There are several circumstances in which a buy-sell agreement is helpful, some of the most common include:

When An Owner Wishes to Sell His/Her Interest

When one of the owners wants to exit the business and wishes to sell his or her stock, the buy-sell agreement protects the other owners by requiring that that stock first be offered to the corporation and/or the other shareholders so the stock may be kept in the “corporate family” instead of bringing in outsiders with whom the remaining owners have no relationship.

The Retirement or Death of an Owner

At some point, most of us plan to retire. When a co-owner decides to retire and leave the business, it could create a great deal of uncertainty about who will take his/her shares of the company. There may also be more unexpected circumstances, such as the disability or death of a co-owner that could make it a difficult transition period for the business. A buy-sell agreement can help smooth this transition by determining who is allowed to buy into the company when one owner leaves for retirement or health reasons.

When an Owner Divorces

California is a community property state; meaning that all property and earnings acquired during a marriage are considered to be owned equally by both spouses. So if one of the partners in your Silicon Valley business gets divorced and you do not have a buy-sell agreement, there is a very good chance that part of your company will end up being owned by an ex-spouse. A strong buy-sell agreement will help avoid this scenario by requiring the ex-spouse to sell all ownership interest back to the other owners or the company under the specific terms and conditions of the agreement.

When an Owner Files for Personal Bankruptcy

If one of the co-owners files for personal bankruptcy, it can jeopardize the entire business. In fact, it is possible that the bankruptcy trustee could order the liquidation (sale) of the business in order to help satisfy the personal debts of the bankrupt owner. Under the terms of a buy-sell agreement, an insolvent owner can be required to notify other partners before filing for bankruptcy, with such notification constituting an automatic offer to sell his/her interest back to the other owners (or the company). This allows the business to avoid getting tied up with bankruptcy proceedings should one of the owners face personal financial difficulties.

Estate Planning

Buy-sell agreements can be used effectively in family-owned businesses to reduce estate taxes when passing the company on to the next generation. The key here is to use a conservative business valuation method as a basis for the sale. This can allow your heirs to purchase the business at a price considerably lower than the likely sale value at the time of death.

Important Considerations with Buy-Sell Agreements

There are several things to consider when developing a buyout agreement for your Silicon Valley business. These include:

• Essential Ground Rules -The most important elements of a buy-sell agreement are the rules around who is allowed to purchase shares of the company and when. Your business attorney should sit down with all parties and go over every potential scenario before drafting the agreement. For example, the owners of a business based in Palo Alto may have certain family members, friends and associates they deem acceptable as potential future partners. At the same time, there may be others who, for whatever reason, are not wanted as part of the company. There should be clauses outlining what events can trigger a sale (such as those previously mentioned; retirement, disability, death, divorce, bankruptcy, etc.), who is allowed to purchase shares under each circumstance, and how the sale will be funded.

• Business Valuation Methods - There are several ways a business can be valued, depending on the type of operation. For example, if your company mostly owns commercial real estate throughout the Bay Area, a real estate appraisal is likely the best approach. For more complex operations, however, the owners may prefer to perform the valuation based on net income, market value, the value of the assets owned by the business, or a combination of these factors. When the business valuation method is determined ahead of time and written into the buyout agreement, it prevents disputes among owners about how the company will be valued at the time of the sale.

• Terms and Conditions of the Sale - There are times when a 100% lump-sum purchase is either unaffordable or not advantageous for the parties involved. A more flexible arrangement such as 20% down and the remaining 80% paid in installments over several years can help the buyers (and the company) avoid a cash crunch while helping the seller stay in a lower tax bracket and avoid adverse tax consequences. Your attorney and CPA can go over these issues with you to determine the specific terms and conditions that should be written into the buy-sell agreement for your company.

Jeffrey Miller is a Palo Alto business attorney and member of the Palo Alto Area Bar Association (PAABA). He provides skilled guidance on buy-sell agreements and all other legal matters for Silicon Valley businesses. To schedule a consultation, call attorney Jeff Miller today at (650) 321-0410 or email him at jeff@jeffmillerlaw.com.