Regular Review of Your Buy-Sell Agreement is Preventative Medicine

Saul Ewing Arnstein & Lehr LLP

Saul Ewing Arnstein & Lehr LLP

When a business first gets off the ground, the founding owners often retain a lawyer to prepare numerous documents to create the entity and conduct the business. One such document should be the Buy-Sell Agreement, which generally sets forth the rules that govern ownership interests in the business upon the death, retirement, or disability of one of the owners. After its completion, this document is usually filed away with other “stuff accomplished”, quickly forgotten as the owners pursue profitability and success.

Unfortunately, when a Buy-Sell Agreement is ignored, it may become a ticking time bomb. The point to establishing rules to be followed when one of the business owners dies, retires, or becomes disabled is to avoid disputes and unintended consequences. By failing to maintain the agreement to reflect changes in circumstances, the owners risk an outcome that they otherwise would not have agreed to.

A Buy-Sell Agreement, although based on information known when the Agreement is first entered, becomes truly effective when one of the owners dies, retires, or becomes disabled. Which begs the question: What is known about the circumstances that will exist at some future time? Usually, not much. Do the parties know when an event will trigger the Agreement? Do the parties know what (other than death) will trigger the Agreement, such as at what point a person has fully retired or become sufficiently disabled? Can the parties accurately predict the financial condition of the business or themselves, or the value of the business, at that time?

Whatever assumptions exist at inception, as the business matures and events unfurl over time, these assumptions usually go by the wayside. Outcomes agreed upon under the Buy-Sell Agreement are not necessarily what the parties would agree upon immediately prior to a death, resignation or disability that occurs at some later date. Needs change; circumstances change. If a Buy-Sell Agreement directs a specific outcome, however, the parties generally must adhere to that outcome. Failure to do so may trigger many consequences, such as adverse tax implications and heightened risk of a lawsuit.

Predictably, problems also arise if there is no Buy-Sell Agreement. For example, consider that absent such an agreement, a business owner’s death may result in that person’s spouse or children succeeding his interest. The spouse or children thus become owners of the business. Not only will powers to exercise ownership over the corporation be shifted to folks who may have no interest in the business or whose skills at operating the business may be lacking, but the remaining business owners may now owe fiduciary obligations to these people. Did the original owners envision this? Did they plan this?

Consider what may happen if the deceased business owner’s spouse or children are willing to sell the interest back to the remaining business owners. How will price be determined and who will determine it? How will the purchase be structured? What if the deceased shareholder has multiple heirs who don’t agree as a selling unit? How will the buying shareholders come up with the cash? If the buying shareholders have an unfair advantage in setting price, then the deceased shareholder’s heirs will get inadequate value. More than likely, substantial time, effort and expense will be spent by both sides to arrive at an agreement. Will this time and effort distract the original shareholders from running the business? Will the expense adversely affect the business?

It is unlikely that the original owners would envision this outcome or plan for it. Instead, the parties are likely to rationalize an absence of a Buy-Sell Agreement on the basis that they do not have sufficient time or resources to work through it. Or perhaps the parties simply believe that the remaining owners and the heirs will “do the right thing” and work out a solution in everyone’s best interest, cordially and at minimal expense. This is wishful thinking at best and destructive planning at worse.

Death of an owner is not the only time when an adverse outcome results. Consider what may happen if one business owner becomes incapacitated and is not able to contribute to the continued success of the business. Should the remaining owners have the power to compel the incapacitated owner to exit the business? At what point? Should the incapacitated owner have the power to compel the remaining owners to buy him or her out? At what point? Should the incapacitated owner have a continuing stake in future profits on the basis that future profits could only have arisen by virtue of the efforts undertaken in earlier years? Or should any future profits earned after the incapacity flow to the incapacitated owner?

A Buy-Sell Agreement is necessary not to the initial or even the ongoing success of a business, but rather to the continued success after one of the owners is no longer involved in the venture. Simply having an agreement is not a panacea. It is crucial for the owners to review the Buy-Sell Agreement on a regular basis, to ensure that as their personal circumstances change and business’s fortunes change, the Agreement changes with them. This exercise should be carried out not only for the business and the business owners themselves, but also for the families of the business owners. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Saul Ewing Arnstein & Lehr LLP

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