(This column originally appeared in The Philadelphia Inquirer)
When a business is started, there’s always plenty of paperwork to complete, such as permits, licenses, articles of incorporation, payroll forms, and tax returns.
But there’s one document that’s crucial at this stage and often overlooked: a shareholder agreement, more commonly referred to as a “buy-sell” agreement. And if you don’t have one in place, you could be very sorry someday.
“I think it’s one of the most important business documents that an owner needs to have,” said Chris Snider, CEO of the Exit Planning Institute, a national nonprofit organization that advises business owners on succession strategies and that has a chapter in Philadelphia. “This is a binding contract that’s in place that oversees or specifies how business interests are to be transferred under certain conditions. I would elevate it way up there, similar to having a will.”
Your company needs a buy-sell agreement if it has more than one partner, or multiple investors, or if family members are employed now or could be in the future.
A good version of this document will serve as a road map for any future ownership issues that may arise. For example, what if an owner unexpectedly dies or gets divorced? What if an owner wants to increase ownership or sell a stake? What if new investors want to come in? Or what if a shareholder becomes incapacitated, is found guilty of a crime, or otherwise can’t perform the duties?
Unfortunately, even though the U.S. Small Business Administration reportsthat more than half of U.S. small businesses are owned by people older than 50, it turns out that only one-third of these owners — according to a recent study from accounting firm PwC — have formal succession plans in place.
If your business is one of the many that doesn’t have a formal agreement already, it’s important to get one in writing. Here are a few must-haves in a buy-sell agreement.
For starters, you’ll want the agreement to always show a current list of all owners and the number of shares they hold in the company.
Next, you’ll want to define your “triggering event” that would require all the owners to consult the buy-sell agreement. A triggering event can occur when an existing shareholder expresses a wish to sell shares to an outsider or a family member. Or it can be when a shareholder dies, retires, goes bankrupt, gets divorced, or becomes disabled.
Most buy-sell agreements also get triggered if a shareholder is involuntarily terminated by the company because of certain issues — such as committing fraud or workplace violations — or because of job performance.
“All of these contingencies must be thought about in advance,” said Peter Klenk, a Philadelphia-based estate planning lawyer. “It’s important to talk to a legal expert early and make sure you’re addressing anything that could occur.”
When a triggering event happens, the buy-sell agreement should address how a change of ownership would occur. For example, it should speak to whether the sale of any shares — to an outside investor, or family member, or existing shareholder — requires approval of the other shareholders. It should also address what happens when an owner dies and there’s a surviving spouse.
“The last thing a business owner wants is to be in partnership with a spouse of a former owner who’s now deceased,” said Steven Fromm, an estate planning lawyer based in Center City. “And it’s also possible that the spouse doesn’t want to be dependent on the company’s success.”
A buy-sell agreement should be specific as to how the business is valued when a triggering event occurs. Usually an outside appraiser is involved, at company expense. But it’s important not to wait for a triggering event to get a company valuation. Fromm encourages his clients to reassess the “certified value” of their businesses every year to avoid any future disagreements.
“Each year, we tell our clients to get their shareholders together and agree on the company’s valuation,” he said. “And then we write out a certification that confirms the value. It gets attached to the company’s minutes and becomes an addendum to the shareholder’s agreement.”
Fromm said that if clients miss conducting a valuation for a year or two, a good buy-sell agreement will include a cost of living adjustment to modify a company’s value automatically.
Once a buyout price is determined, funding will need to be addressed. In many cases, a buy-sell agreement will include requirements that the company maintain insurance in case a potential buyer cannot get the financing to purchase shares.
There are always estate planning issues to be considered, too.
“I’ve had situations when somebody leaves their shares in their will, but their buy-sell agreement has something completely different,” Klenk said. “The two documents have to be consistent.”
Finally, what if there are disputes? In that case you’ll want to make sure you’ve got some sort of resolution mechanism laid out in the agreement. Usually this will be an arbitration process by an independent party or the company’s board of directors.
Just creating the buy-sell agreement at the time of start-up isn’t enough. Most lawyers recommend updating this document regularly — every few years or so — to address changing conditions of the business and its equity partners that could affect the original terms of the agreement.
Problems become larger when they’re not addressed early on, Snider said.
“We know that every business owner will exit their business,” he said. “When there’s no buy-sell agreement in place, or if it hasn’t been updated in a while, there are usually lawsuits.”