Texas Business Dispute Blog

Thursday, February 5, 2015

The Buy-Sell Agreement a/k/a The “Corporate Pre-Nup”: What Is It, and Why Is it a Vital Part of The Business Plan for Private Companies (and Their Investors)?

By Ladd Hirsch (Dallas)

“From a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.” [1]

Every great business begins with a superb product or service that provides the company with a marketplace advantage.  Yet, many potentially great companies flame out relatively early in their existence when conflicts arise among the founders regarding their vision for and direction of the company.  No contract term can immunize a company from future ownership disputes, but a buy-sell provision provides a vehicle for resolving the ownership conflict because it provides for an exit strategy that enables or requires one or more of the owners in conflict to leave the company.  That is why in our practice we refer to buy-sell provisions as “corporate pre-nups” that, when necessary, will facilitate a so-called “business divorce” among the owners of the business. 

As creative as they are, entrepreneurs are often so focused on the development of their product or service, they fail to consider how to structure the company’s ownership and succession plan.  It is critical, however, for both the controlling majority owners of the business and minority investors who may want to leave the business in the future to provide for an exit strategy.  A buy-sell provision is the euphemistic term that provides a contractual means for majority owners to buyout the interests of the minority owners in the company and for minority owners to be able to cash-out and leave the business, i.e., to monetize their otherwise illiquid interest.

Critical Importance of Buy-Sell Provisions

The importance of securing a buy-sell agreement cannot be overstated.  The buy-sell agreement should be obtained either at the outset of the business or at the time the investment in the company is made.  It provides a plan for future events, many of which are not anticipated, but which may include all of the following:  (1) the death, disability or divorce of a partner/investor, (2) an investor who needs to leave the business on short notice, (3) criminal conduct or bankruptcy filing by a partner, (4) actions by a partner that put the business at risk, such as disclosing the company’s trade secrets or engaging in competitive behavior and (5) conflicts arising among the owners regarding the desire to raise capital or assume debt.

In the absence of a buy-sell agreement, fights are likely to erupt among co-owners that are highly disruptive, if not devastating, to the business.  These “business divorce” battles among the co-owners of the company are so fundamental to the business that the resolution of the dispute may require the company to shut down, force a sale of the entire business for a low-ball price, or result in expensive and protracted litigation with the departing minority investors.

In practical effect, the buy-sell provision operates to break deadlocks that arise between the majority and minority owners of the business.  The buy-sell provision is able to break this deadlock by forcing at least one party to exit the business. Specifically, once one of the parties triggers the buy-sell provision, it leads inevitably to at least one party leaving the business.  The mandatory nature of the process led to a number of colorful names being used to describe the buy-sell provision, which include all of the following:

  • The Shotgun Exit
  • A Texas shootout
  • A push-pull option
  • The Cutthroat Buyout
  • A Russian Roulette Exit

Not surprisingly, the best time to negotiate and implement a buy-sell agreement is when the business is being formed.  At the entity formation stage, the founders/investors are on good terms and optimistic about the company’s prospects.  Down the road after the partners are in conflict over the direction, finances and value of the business, it is likely to be very difficult for them to reach agreement on an exit strategy.

Further, the Texas Supreme Court in Ritchie v. Rupe held last year that minority shareholders no longer have the right to secure a court-ordered buyout based on oppressive conduct by the majority owner.  Our Blog discussed the impact of that decision here and here.  For this reason, the Court uncharacteristically took the opportunity to offer legal advice to minority owners considering an investment in a private company.  The Court recommended that minority investors enter into a contract at the time they made their investment to ensure that they would have the right to obtain a buyout of their interest when they are ready to cash out.

Different Types of Buy-Sell Agreements

There are several different types of buy-sell provisions or agreements, but three of the most common are:  (1) the “co-owner buy-out” in which the  owners of the business agree to purchase the ownership interest of the departing investor, (2) the “redemption agreement” in which the company agrees to purchase the interest of the exiting owner and (3) ”right of first refusal” which gives the company and the co-owners the right to first purchase the departing investor’s interest before it is offered to any third parties, or alternatively, which gives them the right to match any third-party offer.

Once the owners of the business have decided to put an exit strategy in place, the negotiation and drafting of a buy-sell agreement is straightforward.  It is also a helpful exercise for the owners to go through the process as they will be required to consider and implement a succession plan.

The elements of a buy-sell agreement consist of the following: 

  • Time for Exercise -  The agreement will provide the time at which the owner can exercise/trigger the right to leave the business (the owners may decide that no investor can cash out for a period of years after the business has formed);
  • The Right to Trigger – the buy-out enables a minority owner to secure a buyout from the company and/or from other owners, but may also include a redemption right in which the majority owners(s) have the right to redeem (repurchase) the minority owner’s stake in the company.  This provision therefore defines what events may give rise to the right to trigger the option, e.g., the departure of the investor from the company, or the right may exist at all times at the discretion of the parties; and
  • Valuation – one of the most important parts of the buy-sell agreement is the means or formula by which the value of the departing owner’s interest in the company will be determined.  This is often the most challenging part of the buy-sell agreement to negotiate, but it is rare for an impasse to be reached when the valuation aspect is being considered at the outset of the business before it has achieved any value whatsoever.

Final Thoughts - Pitfalls to Avoid

There is no “one size fits all” buy-sell agreement that should be adopted by every new private company.  Instead, each buy-sell agreement must be custom tailored to fit the specific needs and goals of the business owners.  There are some common pitfalls that can be avoided, however, which are summarized below.

First, buy-sell provisions that provide for minority owners to receive low-ball valuations at the time they exit the business are far more likely to lead to litigation with departing investors.  Low ball valuations are those that limit the departing investors to receiving book value rather than market value for their interest.  Nevertheless majority owners certainly have the right to provide a book value exit price to minority investors, and if they do so, the buy-sell agreement should spell this out clearly and explicitly to demonstrate that the minority made an informed choice in accepting this valuation. 

Second, private companies often have significant cash flow and liquidity issues.  Therefore, it is generally advisable to require that any buyout of a departing investor’s interest by the company be paid to the investor over some extended period of time rather than on a cash upfront basis.

Third, there are many different formulas for valuing a minority ownership interest in a privately held business.  One of the critical valuation issues is whether the minority interest will be subject to discounts for lack of marketability and lack of control.  Any valuation formula should therefore state expressly whether these “minority discounts” will be applied in the valuation process or whether the minority investor will, instead, receive an enterprise or fair value that is not subject to discounts.

Fourth, given that valuation is so central to the buy-sell provision, the parties should also consider whether they want to require that any dispute about valuation be subject to arbitration.  The parties can specify that the arbitration hearing take place promptly (within 90 days or less), which will permit them to secure a prompt, final resolution of the valuation dispute that avoids a drawn out, public court battle.

Conclusion

The corporate pre-nup is a critical provision that both entrepreneurs and investors should put in place to provide for an exit strategy when the business is formed or when an investment is made.  This type of business planning provide all stakeholders with greater certainty and helps to avoid or lessens future ownership conflicts.


 

[1] Charles W. Murdock, The Evolution of Effective Remedies for Minority Shareholders and Its Impact Upon Valuation of Minority Shares, 65 NOTRE DAME L.REV. 425, 425 (1990).


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