Time for A Buy/Sell Agreement? Private Company Owners May Need to Put a Partner Exit Plan in Place

Originally published by Ladd Hirsch.

“Adversity does not build character, it reveals it.”

James Lane Allen, Novelist, 1849-1925

The sudden onset of the Coronavirus has required private company business partners to confront unprecedented challenges.  In some cases, the partners’ actions in dealing with the Pandemic have led to conflicts revealing incompatible views between them in how to operate the business in a time of crisis.  As a result, the partners may want to engage in a Business Divorce after the virus subsides, but separating one or more business partners from the company is not likely to be simple or smooth if they have not already put a buy-sell agreement in place.  Fortunately, the absence of a current buy-sell agreement is not an insurmountable hurdle if the partners will take the time to negotiate and adopt a mutually beneficial partner exit plan.  Reaching agreement on a buy-sell agreement is a critical step for business partners to avoid a prolonged and expensive conflict that will be both disruptive to the company and also potentially destructive to their personal relationship.

This post discusses the key factors that both majority owners and minority investors will want to consider in negotiating a mutually acceptable buy-sell agreement that allows for partners to depart the business on amicable terms in the future.

The Trigger Point

The first question business partners will need to address is when the buy-sell agreement can be triggered.  To be fair to both sides, the parties will both want the right to trigger a buyout or redemption.  From the majority owner’s perspective, he or she may not want to be required to remain in business with the minority investor.  The majority owner will therefore want to secure a “redemption right” to repurchase the investor’s ownership interest at some point.  By the same token, the minority investor will not want to be stuck holding an illiquid, unmarketable interest in the company with no exit right.  The minority investor will therefore want to ensure to obtain a “put right” that enables the investor to secure a buyout from the majority owner and the right to monetize the investor’s ownership interest in the company.

Given the nature of the current health crisis, the partners may want to agree to what is known as a “delayed trigger” on the buy-sell agreement.  Specifically, after the agreement is put in place, neither side, majority or minority owner, will have the right to trigger the buy-sell for at least two years in the belief that this length of time will allow the company to get fully past the crisis before any buyout takes place.

The minority investor will also need to secure protection regarding the timing of the majority owner’s exercise of the buy-sell agreement.  The minority investor does not want to sell its interest to the majority owner only to see the owner sell the business just a few months later at a much higher value than the minority investor received for its ownership stake in the company.  The minority investor will therefore want to include a “look back” provision as part of the buy-sell agreement.  This provision ensures that if any transaction takes place within a set period of time (often one year) after the minority investor’s interests was redeemed by the majority owner, the investor will then receive an additional payment to equalize the value it would have received if it had remained an owner in the business when the later transaction took place.

The parties will also want to provide a notice period before the buy-sell agreement is exercised so that there is no surprise and the other partner has ample time to prepare for the transaction.   In some cases, a full six months notice is required before a party is permitted to trigger its rights under the buy-sell agreement.

The Valuation Determination

After the buy-sell agreement has been triggered, the next key issue is how to determine the value (purchase price) that will be paid for the minority investor’s interest in the business.[1]  In this regard, the parties must decide whether any “minority discounts” will apply in calculating the value of the minority owner’s interest.  Business valuation experts commonly apply discounts to the value of a minority interest in a private company based on the lack of marketability and lack of control the minority investor has in operating the business.  These discounts can be very steep, as much as 60% from the market value of the interest.

The majority owner may seek to have one but not both minority discounts apply, or alternatively, the majority owner may agree that no discounts will apply, but only if the minority investor does not trigger the buy-sell for a period of years.  For example, the buy-sell agreement may provide that no discounts apply if the investor waits a minimum of number of years before exercising the put right, but if the investor exercises this right before the waiting period ends, the minority discount for lack of control will apply.

In addition to deciding whether minority discounts apply, and if so, to what extent, the parties also have to decide how to determine the value of the business.  They can chose a defined formula for determining value, such as a multiple of revenues.  More commonly, the parties will agree that the party who triggers the buy-sell agreement will retain a business valuation expert to determine the company’s value with or without minority discounts.  When a business valuation expert is retained, the non-triggering party will have the right to retain his or her own valuation expert to provide a competing valuation.   Finally, if the two valuations are more than 10% apart, the agreement will require the parties to have the two experts retain a third expert and then all three company valuations will be averaged to come up with a final number.

The Structured Buyout Payment

Once the value of the business has been determined, it is very rare for the minority interest to be purchased in cash for one lump sum at closing.  What is far more common is for the purchase price to be paid to the minority investor in a structured buyout over a number of years.  The negotiation of the payout of the purchase price will include a number of factors, including: (i) what cash amount will be paid up front, (ii) the length of time the majority owner has to pay the balance for acquiring the minority interest, (iii) whether interest is paid and, if so, at what rate, and (iv) what collateral, if any, will the majority owner provide in the event there is a default in payment of the purchase price.

Conclusion

The extraordinary challenges that private company business partners have faced during the Covid-19 crisis may have highlighted significant differences between them indicating that a Business Divorce will become necessary at some point in the future.  The process of separating business partners from the company often leads to hotly contested disagreements between them, however, if they do not already have a buy-sell agreement in place.  While partners still remain on reasonable terms, now may be a good time for them to negotiate and adopt a buy-sell agreement. A partner exit plan that is documented in a buy-sell agreement is designed to avoid future headaches for business partners when they exit the company, as well as limiting conflicts between them that could seriously damage their personal relationship.

 

[1] In some buy-sell agreements, the minority investor has the right to submit an offer to purchase the majority owner’s interest in the business.  In that event, the majority owner will retain the right to turn the purchase offer back to the minority investor and require the investor to sell its minority stake in the company to the majority owner using the same value included in the minority investor’s offer.

Curated by Texas Bar Today. Follow us on Twitter @texasbartoday.

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