Shareholder Buyout Agreements

Buyout agreements or buy-sell agreements are used in many types of business structures. This includes corporations, limited liability companies, and partnerships. A buyout agreement can limit or restrict a shareholder’s ability to sell or transfer shares when leaving a company.

Let’s dive into more information about these important agreements.

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What Is a Buyout Agreement?

A buyout agreement is a contract among a corporation’s shareholders. It controls the transfer of shares. These agreements outline how a shareholder can sell their business interest. This agreement is essential for both business owners and key employees. It often includes clauses like the right of first refusal and transfer restrictions. They might also include valuation methods to find the market value of the shares.

A buyout agreement determines the following:

• Who can buy a shareholder’s stock

• Whether the company must buy the shareholder

• How to measure the value of a shareholder’s interest

• Payment terms for a buyout

A buyout agreement ensures that a company can prohibit an unwanted buyer from gaining an interest in the company. They also determine how a shareholder can dispose of an ownership interest in a company.

Shareholders of a corporation usually include buyout agreements in the articles of incorporation, or they can include them in the corporate bylaws. Finally, they might also include them in a separate, written agreement.

Shareholder buyout agreements are designed to protect the business, the remaining owners, and even a deceased shareholder’s estate, ensuring smooth ownership transition and continuity.

Top Reasons for Buyout Agreements

Buyout agreements ensure protection and predictability and serve several purposes:

• Protecting Minority Shareholders: They ensure that minority shareholders receive fair treatment. They also ensure shareholders receive a reasonable purchase price for their shares.

• Estate Planning: In the event of the death of a shareholder, these agreements help in transferring shares. This aids in smoother estate planning and avoids legal disputes.

• Maintaining Business Continuity: They help keep the business running smoothly by outlining clear rules for the transfer of shares. Without an agreement, shares could be offered to competitors or inherited by disinterested or inexperienced family members.

• Establishing a Fair Value. An agreement provides either a purchase price or a clear method for establishing value of the departing owner’s shares.

• Protecting Business Vision. A buyout agreement prevents outsiders who do not share the culture or vision of your business.
  
  

Buyouts When Certain Events Occur

Buyout agreements determine what events will start a buyout. Most agreements identify the following triggering events:

• Personal Bankruptcy: Buyout agreements usually allow a company to acquire the interest of a bankrupt shareholder.

• Death: If the buyout agreement requires, the decedent’s family may be required to sell the inherited share back to the company.

• Retirement: When a shareholder is no longer active in the business, many agreements allow for the acquisition of a retiree’s interest when the shareholder reaches a certain age.

• Divorce: An agreement may require the ex-spouse of a shareholder to sell the acquired ownership interest back to the company.

• Disability or Incapacitation: A buyout agreement can compel the sale of a shareholder’s interest after the determination of a permanent disability.

• Termination of Employment: Some buyout agreements force a terminated employee to sell their interest back to the company. This provision is intended to prevent the former employee’s continued access to private company information.

Triggering events activate the buyout agreement. The remaining shareholders of the business itself may have the opportunity to buy the departing shareholder’s shares. This process helps in maintaining control and stability within the company.

The Main Types of Shareholder Buyout Agreements

There isn’t one perfect buyout plan for every business. The right choice depends on how your company is set up, how many owners there are, and how a buyout would be funded. Two common types are cross-purchase agreements and stock redemption agreements.

Cross-Purchase Agreements: Owners Buy Each Other Out

In a cross-purchase agreement, the shareholders themselves agree to buy the shares of any owner who leaves or passes away. Typically, each owner has life insurance policies on the other owners. If one dies, the survivors use the insurance proceeds to buy the deceased owner’s shares from their estate.

Stock Redemption Agreements: The Company Buys the Shares

In a stock redemption agreement, the company itself buys back a departing owner’s shares. In this scenario, the company owns life insurance policies on each shareholder and uses the proceeds to buy the shares back from the deceased owner’s estate.

Hybrid Agreements

Many businesses opt for a hybrid approach, offering greater flexibility and the ability to tailor the buyout process more precisely to the company’s unique needs.

A common hybrid structure involves a “first-right-of-refusal” approach:

1. First Option to the Company: The agreement might stipulate that if a triggering event occurs, the company has the first right to redeem the shares. This provides the administrative simplicity and single funding source of a stock redemption.

2. Second Option to Remaining Shareholders: If the company declines to purchase all or part of the shares (perhaps due to financial constraints or strategic reasons), the remaining shareholders then have the option to purchase shares themselves, similar to a cross-purchase agreement. This allows them to benefit from a stepped-up basis if they do acquire shares directly.

How To Fund a Buyout

Funding a buyout can be challenging. To buy out a shareholder, a company must be able to pay for the value of the ownership interest. A company can fund the purchase of a shareholder’s interest by using:

• Insurance Policies: This is often used in the case of the death or disability of a shareholder. Many companies purchase life insurance policies, and sometimes disability insurance policies, for each shareholder. If the shareholder dies or becomes permanently disabled, the company can use the proceeds of the policy to buy out the deceased shareholder’s interest.

• The Assets of the Business: A buyout agreement may stipulate that the company can pay over time with the income earned from the business. This is in the form of installment payments. For example, a payment plan may allow the remaining owners to put 20% down and pay the remaining balance in installments over five or 10 years.

• External Funding: Some businesses may seek funding from outside sources. Businesses may seek loans or investors to fund buyouts. This can provide the necessary capital without straining the company’s cash flow.

• Liquidation of Assets: In some cases, the company may opt to liquidate certain assets to finance the buyout. They might convert these assets to fund the purchase of the existing shareholder’s shares.

Each of these options has its own implications and should be considered carefully in the context of the company’s financial health and long-term strategy. An attorney can help provide valuable legal advice and guidance in these situations.

Get Professional Legal Help When Drafting a Shareholder Buyout Agreement

One thing that is constant in any business is change. Market conditions, trends, demand for certain goods, pricing, and even global events can impact the direction of a corporation. In addition, the sudden departure of a key officer can potentially throw a business into chaos.

Talk to a business and commercial law attorney to learn more about how a shareholder buyout agreement can help your business weather such changes.