Why California Corporations Should Have a Well-Crafted Buy-Sell Agreement

By: Gurshaan Chattha

A buy-sell agreement protects a corporation’s interests if a shareholder needs to or wants to exit the business or wants to bring in a new owner. California corporations with more than one owner or shareholder should work closely with their attorneys to build a strong buy-sell agreement and avoid expensive conflict related to shareholder exits and entries.

A buy-sell agreement can help corporations:

• Protect the value of their business interests
• Protect their business from third party interference
• Provide a straightforward way to divide the business if a shareholder wants to be bought out, is forced out, or faces an unpredictable life event, such as divorce, bankruptcy, death, or disability

Choosing a Valuation Method

Different valuation methods may be preferable to different owners. Each business is unique, with a different mixture of assets and sources of income, so owners should work closely with their accountant to determine which method of valuation is the most fair to all parties when it comes time to sell part or all of the business. Owners should agree on a method of business valuation and record this choice in their buy-sell agreement. They can also agree on which third-party valuation firm they will use in advance.

Ownership Rules

Business owners should consider whether they want to limit who can become an owner in their business. In California, one owner’s retirement, divorce, death, or bankruptcy could enable someone else, such as a spouse or estate, to be entitled to part of their interest in the business. Owners can decide to add rules to the buy-sell agreement that require shares be sold back to the business if they were obtained without permission of the other members. The agreement can also specifically exclude certain people from owning a portion of the business.

Additionally, the buy-sell agreement can require that an owner sell their shares if they retire and stop actively participating, or it can allow owners to keep their shares but give up voting rights.

When to Perform Buyouts

Owners should agree that certain events will trigger a buyout in their buy-sell agreement. These can include if a shareholder:

• Commits acts that may harm the business or expose other shareholders to potential harm, such as fraud
• Faces unpredictable events, like:
  • Death
  • Disability
  • Bankruptcy
  • Divorce

Additionally, the buy-sell agreement can give the shareholders right of first refusal if an owner wants to sell their interest to a third party. Typically, business owners will craft their buy-sell agreement to dictate that if they refuse the third-party offer, they must purchase the shares on the same terms and at the same price as the outside offer.

Conditions of Sale

It is important for owners to agree on which processes they will follow when selling all or some of the business’s shares. Some factors to consider include:

• If a business offers to buy your company, do you require approval of all owners on the sale, or just a majority?
• Do processes differ based on whether only some of a business’s shares or all the shares are up for sale?
• Where would the money come from to fund a buyout? Should the business maintain a “sinking fund” cash reserve to buy out a departing owner?
• Should the business have a life insurance policy for each of the owners?
• Does a sale have to made in one lump sum, or can it be split into payments?

Your experienced attorney can help you write a well-defined set of terms related to sales in the buy-sell agreement to make the process smooth when the time comes.

Frequently Asked Questions about Buy-Sell Agreements

In addition to considering your valuation method, ownership rules, and conditions of sale, business owners should also consider the following:

• How can the company ensure they can afford a buyout?
  When drafting your buy-sell agreement, consider adding special provisions that enable the business to afford a buyout – such as a payment plan, requiring life or disability insurance for all members, and maintaining a sinking fund.
• How could divorce impact the business?
  In community property states like California, spouses can receive a portion of the business in their divorce. Be sure to draft your buy-sell agreement with this possibility in mind – should spouses be allowed to keep their portion of the company, or should they be required to sell it back to the business?
• What happens in the case of bankruptcy?
  If one of the owners files for bankruptcy, it can put the business in jeopardy. Be sure to consider with your attorney what to do in this case.

Conclusion

Business owners and shareholders will inevitably need to exit the business, and there may be opportunities to add new ones, too. A well-crafted buy-sell agreement can help the corporation continue operating smoothly, fairly compensate departing shareholders, and save time and money on legal battles. Contact your Chugh, LLP attorney for help developing a powerful buy-sell agreement that protects your business.