GPSOLO September 2010
BUSINESS AND COMMERCIAL LAW
Drafting Buy-Sell Provisions in Shareholder Agreements
By Mark R. High
The rule is simple—every closely held corporation with more than one shareholder needs a shareholder agreement. The heart of most shareholder agreements is the right or obligation of one shareholder to buy the shares of another shareholder when certain events occur. This article reviews some of the most common provisions included in the buy-sell portion of a shareholder agreement and describes how the parties can use insurance products to help get a company past a shareholder’s death.
A variety of options. A company and its shareholders should anticipate and plan for any special event that could alter the shareholder group. Death, disability, retirement, and employee terminations are all events that a company might address. Although the list of events may be relatively fixed and routine, each company will have its own way of approaching the situation, and the approaches may vary based on the event or the shareholder affected by it. The company also can craft different approaches to different situations. Some agreements provide for mandatory purchases by the company. Some give the company the option to purchase.
What triggers a purchase? Certainly death and disability are commonly covered. Where the shareholders are employees, a change in their employment status may prompt a change in their equity status. Voluntary and involuntary terminations can be covered, with different results sometimes flowing from a voluntary termination or one with cause, rather than without cause.
Defining the events is critical, too. Disability is especially tricky. There is a different definition in virtually each agreement. Early retirements also can get complex, especially in professional corporations where losing a productive fee-earner in a rare specialty can leave a hole in the practice.
Who buys? Once a situation is identified, the company needs to decide what it wants to do with the affected party’s shares. Mandatory purchases, mandatory sales, options to purchase, and options to sell are each a justifiable outcome. Purchases can be made by the company itself (redemptions) or by the other shareholders. Often, the company is given the first right to purchase, with the shareholders available to step in if the company cannot or does not do so. Generally, the shareholders split up the available shares in proportion to their holdings among themselves. It is generally good to require all of a shareholder’s shares to be purchased, rather than only a part, so that (1) the affected shareholder is not stuck holding a very small piece of the company with no further connection and no practical way to get out and (2) the remaining shareholders do not get an opportunity to perhaps vindictively force an exiting shareholder into a minority position.
This decision regarding the purchaser raises several factors to consider. First is the funding issue: Who can pay? Second is a tax concern: Redemptions are sometimes treated as capital gains but also can be given deemed distribution treatment, resulting in an unfavorable event for the selling shareholder. Third is the effect on the company’s control structure. Fourth is the statutory limitations on a corporation’s ability to make distributions that would render the company insolvent. Fifth is the company’s loan documents, which may include limitations on payments to shareholders or changes in control.
What price will be paid? When working with internal purchases among the company and its shareholders, the parties need to establish a price for the shares to be transferred. (In a third-party outsider purchase, this is established by the outsider’s offer, which is, almost by definition, a market price.) The standard buy/sell agreement will establish its own procedure for valuing the company and arriving at a fair purchase price.
Companies use annual appraisals, internal agreed-upon values, values based on book value, sales, EBIT (earnings before interest and taxes), EBITDA (earnings before interest, taxes, depreciation, and amortization), asset values, a formula special to their industry, or some combination of the above. Appraisals may seem expensive but can provide the most supportable valuation if the company anticipates a challenge or objection.
Buyer-financed buyout. There are few rules that are universal. Here is one approaching that standard: Sellers like cash at closing. In most shareholder settings, this is not a practical alternative. A lump-sum buyout ties up cash that could be used as working capital or currently paid out to the other owners.
The other way that sellers can be paid out is through the company’s borrowing the purchase price under its credit line with the bank. This puts the funding cost fully on the borrowing company in the form of interest payments and reduced credit availability to fund the business.
Seller-financed buyout. More common is a deferred purchase price. Often, there will be a significant down payment at closing, with the company issuing a promissory note to evidence the remaining payment obligation. Typically, the note is subordinated to the company’s senior credit facilities. The selling shareholder is entitled to interest at a rate that reflects the circumstances and credit risk involved. The sale is generally effective at closing, and the former shareholder assigns its shares to the buyer.
Funding a buyout through insurance. The down payment can be a critical part of a buyout brought about by a shareholder’s death. Not only can it serve to reduce the outstanding amount owed, easing the buyer’s ongoing payment burden and reducing the seller’s credit risk, it might be needed to allow the seller to meet his or her estate tax obligations. It can be a burden, however, for the buyer (whether company or shareholder) to come up with a lump sum on perhaps little or no notice. One approach is to have the company purchase a term life insurance policy on each of the shareholders to cover at least the down payment obligations. One difficulty with shareholder-purchased policies is simply making sure each shareholder keeps up with the premium payments to keep the policies in place.
Cross-insurance. An insurance program can be rather straightforward in a company with two shareholders—either the company purchases a policy on each shareholder or each shareholder buys one on the other. More shareholders make for difficult cross-insurance situations. With three shareholders, each one now needs two policies on the others, meaning a total of six policies. The problem only escalates from there.
The same problem exists where there are several related companies with identical, or overlapping, shareholder bodies. Some clients have both these situations—multiple shareholders and multiple companies. Designing a traditional cross-insurance program here would be impossibly complex, and yet the same concerns still need to be addressed.
Cross-insurance trusts. There is a relatively simple way to solve this problem: Connect the funding source with the payment obligations at one central point. Each company starts with its own buy-sell agreement, setting out its purchase events and prices, as in a normal situation. The parties then establish a simple trust, and the companies, each of the shareholders, and the trustee enter into a cross-purchase agreement. The trust collects the policy proceeds and distributes them to the appropriate purchaser.