Buy Sell Agreements Defined
Buy Sell Agreements are contracts used most often in the limited liability company or corporate context to provide for the disposition of an ownership interest in the event of certain specified purchasing or selling events. These events typically include the death or incapacity of the owner, sale of the ownership interest to a third party, termination of Employment of a Member or Manager, or determination of a disabled Member or Manager. Any or all of these buyout triggers or events may be eliminated or added by the agreement. A Buy Sell Agreement is usually funded by a life insurance policy on the life of each owner . In these cases the insurance proceeds are paid at death to the business entity, its remaining owners or employees, who then pay the face value of the ownership interest to the deceased’s heirs.
One of the purposes of a Buy Sell Agreement in Montana is to avoid the dilution of a business interest caused by the death, incapacity or retirement of an owner and to set a value on that interest so that all owners are buying at a fair price. It is important for owners of business interests to have a Buy Sell Agreement in place before a trigger event so it is clear what will happen and how much money has to change hands when an owner wants to sell or buys out.
Elements of a Buy Sell Agreement
Key Elements of a Buy Sell Agreement in Montana
Montana business law mandates that key elements be included in an enforceable buy sell agreement. Here, we will discuss some of these key elements.
First, the triggering events are pivotal to any buy sell agreement. These events can relate to a business owner’s death, disability, retirement, insolvency or termination of employment, among others. For instance, a triggering event could be the owner’s decision to sell his or her stake in the business; it could be a family member or heir’s decision to assume that stake; or it could be a decision by a third party to purchase the business. Whatever the triggering event is–and because of the unpredictability of these matters, there are typically several–the event triggers the buy sell agreement so all parties can properly proceed according to circumstances.
Next, the key element of valuation must be properly addressed. After all, how much is going to be paid? And in what manner? Remember, this is not only about the owners, but also their spouses or other heirs who may be involved succeeding the owners in the future. Thus, for example, the purchase price may vary depending on whether the buyer is an owner or spouse. The business may be evaluated at fair market value; at book value; or some other method of valuation, such as capitalization of earnings or a multiple of revenue. Sometimes, it may be a combination of methods, such as a break on the price if the payment terms are extended. Specific valuation methods may even be used for specific types of triggering events. As for the payment terms, as well as the valuation process itself, the business and its owners may want to involve a third-party appraiser.
Finally, the buy sell agreement must consider the important issues of funding. As mentioned above, how will the payment work? Will the deal be financed through cash, a loan or installment payments? Here, the parties may want to consider an insurance policy that they can buy to fund a key person or key people who are crucial to the business operations.
Types of Montana Buy Sell Agreements
There are several types of buy sell agreements which may be either current or deferred. Current agreements require that a purchase transaction be completed during the lifetime of the selling shareholder. These agreements may provide for a redemption of shares by the corporation on a fixed basis or require that the remaining shareholders buy the shares to be sold at a market value or some other value standard. Deferred agreements are made in anticipation of the sale of shares at a future date. The issue of valuation can be addressed through formulas, like book value of a corporation, or the more traditional Black-Scholes model. A professional appraisal done by a qualified appraiser is also an option both for current and deferred purchases.
While stock redemptions are the most common form of buy-sell agreements adopted by closely-held corporations, many companies prefer not to purchase their shareholder’s interests. A cross-purchase agreement is therefore more favorable. This agreement is between the business owners and their respective estates or successors. While stock redemption agreements are also considered entity-purchase agreements, they result in a deduction to the purchasing corporation for income taxes. On the other hand, cross-purchase agreements do not result in any corporate deduction although individual shareholders may be able to deduct premiums paid on insurance. In addition, statutory provisions are available to reduce the estate tax impact of insurance on the death of the insured shareholder. Special issues may exist if the cross purchase agreement is funded by an entity policy or involves more than three to five shareholders.
In a hybrid or wait-and-see agreement, the number of shareholders is reduced while providing an option to purchase a shareholder’s interest. If the option is declined, then the remaining shareholder has the obligation to purchase on the same terms offered by the entity or non-selling shareholders. Such agreements involve the use of entity agreements with the entity holding an option for the purchase of shares under set valuation formulas. There is debate as to the use of such agreements during the life-time of a business owner. An agreement may be an option agreement that is treated as a separate purchase. Another form of hybrid agreement is a combination of entity-purchase and cross-purchase agreements. These agreements take the form of a cross-purchase agreement but allow the corporation to purchase shares from the surviving owners when the stockholders cannot complete the purchase within a given period of time.
Legal Aspects of Agreements in Montana
While the buy sell agreement itself is a contract among the owners of a business, it influences a number of other areas of the law which show how ownership interest in a business can impact on taxes, organization, succession planning and liabilities. A well written agreement will incorporate those nuances into the provisions of the agreement to make the best use of them.
For example, a review of Montana law may identify specific statutory requirements that must be met. For a limited liability company, the provision in the operating agreement (which is the buy sell agreement for that type of entity) must include the process for determining the purchase price of a member’s interest in the event of a withdrawal or other termination event. Even if the operating agreement does not include that provision, the purchase price must be determined by appraisal under a method specified in the operating agreement or as mandated by statute.
For a corporation, without any provision in the articles of incorporation, the shares cannot be transferred except by written consent of the board of directors. There is no transferability upon separation of the spouse. The spouse may only be a transferee for purposes of a divorce or death of the owner.
There are also tax implications under Montana law. In addition to standard capital gains taxes on the sale of the interest, the transfer of an interest in a corporation may trigger the payment of sales tax, like real estate.
An important legal consideration for a Montana buy sell agreement is succession planning. Unless special elections are made, the death or withdrawal of an owner may cause the business to terminate, unless a buy sell agreement provides for its continuation.
Role of the Attorney in Drafting an Agreement
As is the case with almost all legal agreements, it is always advisable to hire an attorney who can draft a buy sell agreement specifically designed for your situation and add in all of the details that will make an agreement comprehensive and effective. Your attorney should understand the ins and outs of buy sell agreements in your state, and your lawyer will ensure that all legal requirements are followed in order to make it a legally binding contract. While the details will obviously vary based upon your particular business situation, there are a number of common provisions that should be included in almost every buy sell agreement .
For example, the agreement needs to include a number of details that will be necessary in order to effectively transfer your business or ownership rights at the time that the transaction occurs. As part of the buy-sell agreement, the attorney should include a purchase price formula to determine the value of the buyout, including such details as:
Your attorney will likely also include information on how ownership percentages are determined, the process for making payments, and what happens in the event of a dispute. Each of these terms will be unique to your business entity types, whether you are a C corporation, an S corporation, or a limited liability company (LLC).
Common Mistakes and Solutions
One of the most common pitfalls that businesses face when it comes to buy sell agreements is lack of clarity about the triggering events. Explicitly defining and reserving the right to purchase the interest once these events occur is paramount in avoiding future litigation over differing interpretations of the triggering events.
For instance, sometimes ambiguity will arise regarding whether a death requires a purchase. The buy sell agreement must explicitly state who must make the determination that the death has occurred, whether it is the surviving owners or the entity itself (or both), as well as the precise language used to describe the event. Similarly, ambiguity can arise based on the substance of an event. For instance, is a death defined as any event that results in the social security number of the member or owner being deactivated? Or must an actual death certificate be provided to trigger the buy/sell? Every business is different, so having this clause explicitly defined is critical.
Another common pitfall is failing to ensure that both parties have the financial means to accomplish the sale. Whether the funds for the purchase are being obtained through financing, a mutual insurance policy, or some other means, the critical issue is that the agreement should clearly state how the funds are being obtained. Without an explicit plan that each party has signed off on, one party could find themselves scrambling to come up with the funds necessary to fulfill the terms of the contract.
A third common pitfall is failing to explicitly define the purchase price. Remember, the price cannot be changed without the consent of both parties, so it is critical to specifically define this in the contract. Without an explicit price and method of determining that price, the parties may run into a situation down the road where they disagree over the exact value of the entity. Assume that two parties have agreed on a formula for fixing the price of their interest in the entity, but one of them later dies. Now the remaining partner has the right to buy out the deceased partner’s estate, worth half of the entity. But the plan for valuing the entity created ten years prior is vague at best, and the parties disagree about how the value is to be determined. In this scenario, the buy sell agreement has become a hindrance rather than a help.
This is especially important when one owner has put in significantly more hours than the other owners. If the business partner that has been putting in more hours gets sick or injured, they need the peace of mind of knowing that the buy sell agreement will protect their interest in the business should they die. Failure to include any one of these provisions could lead to difficult litigation and may prevent the plan from accomplishing its purpose.
Amending a Buy Sell Agreement
It is important to regularly review your buy sell agreement to ensure that the terms continue to reflect your preferences. In addition to reviewing the agreement when there is a change in the owners of the business, it is also essential to review the agreement whenever relevant legislation is passed or amended in the state of Montana . Having an outdated buy sell agreement could create problems for the owners. In Montana, these issues can include creating unwanted tax consequences, or overweighting minority interests in the agreement or increasing the economic burden on the owners.