June 24, 2011

Buy-Sell Clause- It’s Important, Folks…

If you are a partner in a business entity, it cannot be overstated that a buy-sell clause is MANDATORY. Being in business with a partner, in many ways, is like being in a marriage. In fact, some experts who I know refer to business partnerships as “business marriages”. However, one major difference between the two […]

If you are a partner in a business entity, it cannot be overstated that a buy-sell clause is MANDATORY.

Being in business with a partner, in many ways, is like being in a marriage. In fact, some experts who I know refer to business partnerships as “business marriages”. However, one major difference between the two types of marriages is the documentation that you might put before your partner.

If you were to offer a prenuptial agreement to a prospective spouse, you might elicit several reactions, most of them negative. But in a business partnership, a document that absolutely HAS to be in place before the partnership is official is the partnership agreement. Furthermore, an essential part of that agreement is a buy-sell clause.

So… what is a buy-sell clause anyway?

A VERY loose definition ( **please see a business attorney for a more comprehensive definition that applies specifically to you ) is that it’s simply a clause in your partnership agreement that addresses the conditions under which the business, or your portion of it (or your partner’s), would be sold. It also addresses the conditions under which the business would be valued, what assumptions would apply, and the “triggering events” that would cause the agreement to come into play.

Is this important? ABSOLUTELY. Consider, for example, two scenarios- identical businesses with identical financials; in one, the business owner does not have a partnership agreement, or at least not one that has a buy-sell clause; in the other, s/he does. Assume also, in a very simplistic manner for purposes of illustration, that the business is worth $1,000,000 at fair market value, based on a valuation of the company as a going concern; also, the ownership share split is 51%/49%, with the majority owner buying out the minority owner.

In the case where a buy-sell agreement does not exist, the typical resolution to this situation is a direct buy-out of the partner; doing the math (again, in a very simplistic, non-real-world example), the minority owner’s share of the business would be worth $490,000.

However, in the case where there is a buy-sell clause, the partners would have to adhere to the methods of valuation stipulated by the buy-sell clause. So, as an example, if the buy-sell clause stipulated that the value of the company, for purposes of buying the shares of the outgoing partner, is determined by the net assets of the business, and a current balance sheet shows a net asset value of $200,000, we are now talking about a value of the shares of the outgoing partner of $98,000.

So, assuming that you are the majority partner, and you are buying back 49% of the shares of your soon-to-be ex-partner, would you prefer to write a check for $490,000, or for $98,000?

Again- this is a really simplistic example, and there are several more moving parts in a real-world situation. But understand the larger point- being able to state the terms and conditions under which your company should be valued, and what situations would trigger the implementation of those conditions, can be the difference between you being in a really difficult situation if a partner has to leave, or you happily writing a check to get rid of a difficult partner.

Final word: if you do not have a good business attorney- please get one. YESTERDAY.

A few thoughts: