Buy/Sell (Shareholder Agreements)

Recent years have seen an explosion in the creation of small businesses. There are many reasons for this: massive layoffs, business restructuring, the impact of the internet on the workplace – the desire of Americans to shape their own destiny and achieve their own personal security in an uncertain world. The American entrepreneurial spirit is alive and well with millions of individual going on their own forming their own one-member LLC’s, corporations or proprietorships. Often times, however, people join forces because of differing skills, the need for additional capital, or a business owner giving an equity position to a key employee.

An easy way to understand the buy/sell agreement is to think of it as a prenuptial agreement in the event of a business divorce. People openly enter into business arrangements much like they enter into a first marriage – downplaying or totally ignoring potential conflicts. The likelihood of the business divorce, however, is staggering. Statistics show that fully 85% of businesses having multiple owners have been reconfigured within the first three years of business life. Some have simply gone out of business while other have seen one or more owners leave because of a variety of unexpected conflicts. Death and disability are also real life problems. Few business owners want to share their business with their former partner’s spouse.

They buy/sell agreement is a contract among the owners which addresses, in an orderly manner, business transitions. In a corporate setting these agreements are called buy/sell agreements or stock redemption agreements. In a limited liability company setting the document is called an operating agreement. These documents are much the same and ordinarily have these purposes:

  1. To place restrictions on the transfer of ownership interests. These restrictions limit or forbid the sale of an ownership interest to an outside party without the consent of the other owners.
  2. To provide for the orderly transfer of stock interests (membership interests in an LLC or partnership interests in a partnership) on the death, retirement or disability of a partial owner.
  3. To permit remaining shareholders (LLC members) to retain business control, to have veto power over the admission of new owners, and to eliminate conflicts with the departing owner or his heirs.
  4. To create a market at a fair price for the interest of a departing owner.
  5. To provide funding for the purchase of a departing owner’s interest and to fix the value of the business.
  6. To reasonably assure the continuance of the business and reduce the risk of loss in value.
  7. To provide spendable cash or investment funds for the heirs of the deceased shareholder which will meet their needs.
  8. In the corporate setting, to protect an “S” election by preventing transfers to shareholders who are not qualified “S” corporation shareholders.

Perhaps the most important of the provisions in a buy/sell agreement is the restriction of transfer of ownership to an outsider. The general corporation law of Ohio and the statutes dealing with transfer restrictions (Ohio Revised Code Section 1308.11 and 1701.25(B)), while allowing transfer restrictions, do not address the content of share transfer restrictions. The courts have imposed a requirement of reasonableness. Generally, buy/sell agreements require the approval of the remaining owners before any shares of stock (LLC interests) may be transferred.

There are numerous advantages to entering into owner agreements early in the life of the business. In fact, it should be addressed immediately upon formation of the business entity or upon the admission of a new owner. These agreements can go a long way to avoiding deadlock with new owners caused by unanticipated business issues or by death or disability. These agreements dictate the terms of an owner’s disassociation from a business avoiding conflict and enabling continuity of management.