As a lawyer with a small business clientele in Virginia, I am frequently asked about Buy-Sell Agreements. Although most small business owners are generally familiar with the concept of a Buy-Sell Agreement, I find that most do not truly understand the purpose of a Buy-Sell Agreement or the form in which these contracts typically exist. Accordingly, here is a brief primer on Buy-Sell Agreements in Virginia.
What is a Buy-Sell Agreement?
A Buy-Sell Agreement is a contractual arrangement between the owners of a business (e.g., a corporation, limited liability company, or partnership) that sets forth the process by which an ownership interest can be sold upon the occurrence of certain triggering events (e.g., retirement, divorce, bankruptcy, disability, death, or a third-party offer) as well as the price or formula for such sale.
Is a Buy-Sell Agreement a stand-alone contract?
Not necessarily. A Buy-Sell Agreement can either be a stand-alone contract or a series of provisions that are incorporated into the governing documents of a business (e.g., By-Laws for a corporation or the Operating Agreement for a limited liability company).
What are the advantages of having a Buy-Sell Agreement?
By having a Buy-Sell Agreement in place, the owners of a company can completely control the disposition of an ownership interest in the business as well as control the composition of the ownership group. In a closely-held company (such as a small, family-owned business), the ability to restrict the transfer or sale of an owner’s interest in the company is an extremely important consideration as it keeps outsiders from assuming a share of the business.
What are the types of Buy-Sell Agreements?
There are three types of Buy-Sell Agreements:
- Redemption Agreement: The selling owner must either sell his ownership interest to the company or provide the company with a right of first refusal. In essence, the company is “redeeming” the shares of the owner.
- Cross-Purchase Agreement: The selling owner must either sell his ownership interest to the remaining owners or provide the remaining owners with a right of first refusal.
- “Hybrid” Agreement: A Hybrid Agreement is simply a blend of a Redemption Agreement and a Cross-Purchase Agreement.
How is a purchase funded under a Buy-Sell Agreement?
Many small businesses do not have the capital reserves to fund the purchase of an ownership interest. As such, a common approach (utilized by businesses and individuals alike) is to purchase and maintain an insurance policy from which the proceeds (upon the disability, death, or retirement of an owner) are used to purchase the available ownership interest. Other funding options include installment plans and loan arrangements.
For one reason or another, every small business is eventually confronted with the loss of an owner. As such, whether you have a startup company or an existing small business, it is of critical importance that you have a well-drafted Buy-Sell Agreement in place to maintain business continuity and to proactively limit any issues relating to the departure of an owner.