Buy-sell agreements are an integral part of creating a firm foundation for your business. In this week’s episode of the podcast (which hasn’t been published yet, but will be soon), we talk about why buy-sell agreements need to be used and why making sure they are funded is important. Today, let’t talk about what the buy-sell agreement should look like.
There are two primary types of transfers you want to deal with in your buy-sell agreement.
- Voluntary Transfers
- Involuntary Transfers
Today, we will deal with the voluntary transfer of ownership. In a buy-sell agreement, you want to make sure your partners don’t decide to simply sell to the highest bidder. In a small business, the ownership is important to the continuation of the business. Not to mention, you need to consider the securities issues in simply selling some of your shares. This is especially important if your business is not registered for the sale of securities. You do not want to create that as a regulatory requirement. If you are in a business that is not registered to offer securities publicly, you want to make sure you include a disclaimer indicating that the membership interests are not registered and are exempt from being registered. This disclaimer should also restrict any sale of securities that would require a registration of the company. This will further restrict members from offering their business up in a public offering that would require registration of the securities. A common disclaimer would look like this:
THE SECURITIES OFFERED IN THIS AGREEMENT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “FEDERAL ACT”), THE ALABAMA SECURITIES ACT OF 1990, AS AMENDED, OR THE SECURITIES LAWS OF ANY STATE, AND ARE BEING OFFERED AND SOLD IN RELIANCE ON EXEMPTIONS FROM THE REGISTRATION REQUIREMENTS OF THE FEDERAL ACT AND VARIOUS APPLICABLE STATE LAWS. IN ADDITION, THE TRANSFER OF THE SECURITIES IS SUBJECT TO THE RESTRICTIONS ON TRANSFER AND OTHER TERMS AND CONDITIONS SET FORTH IN THIS AGREEMENT. THESE SECURITIES MAY NOT BE OFFERED FOR SALE, PLEDGED, HYPOTHECATED, SOLD, ASSIGNED, OR TRANSFERRED EXCEPT IN COMPLIANCE WITH THE TERMS OF THIS AGREEMENT, AS AMENDED FROM TIME TO TIME. FURTHER, THESE SECURITIES MAY NOT BE OFFERED FOR SALE, PLEDGED, HYPOTHECATED, SOLD, ASSIGNED, OR TRANSFERRED UNLESS SUCH TRANSFER IS UNDER CIRCUMSTANCES WHICH, IN THE OPINION OF LEGAL COUNSEL, ARE ACCEPTABLE TO THE COMPANY, DO NOT REQUIRE THAT THE SECURITIES BE REGISTERED UNDER THE FEDERAL ACT OR ANY APPLICABLE STATE SECURITIES LAWS, OR SUCH TRANSFER IS PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT UNDER THE FEDERAL ACT OR ANY APPLICABLE STATE SECURITIES LAWS.
Notice the all caps of the disclaimer. It is a good idea to make this bold and clear. This disclaimer should be included in any subscription agreement, certificate reflecting ownership, or any other document related to the ownership or purchase of Membership Interests in your company.
Now, let’s look at how to explicitly restrict the voluntary transfers. We will focus on the opening paragraph of a section restricting voluntary transfers of ownership:
8. Restrictions on Voluntary Transfers of Membership. Before any fully vested membership interest held by a Member (the “Selling Member”) may be sold or otherwise voluntarily transferred (including transfer by gift or operation of law) other than to Selling Member’s individual retirement account or a legal entity created to hold interests in the Company that is solely owned by the Selling Member, the Company and the Members shall have a right of first refusal to purchase the membership interest on the terms set forth in this Section (that right, the “Right of First Refusal”).
Let’s break down what is going on in this paragraph.
Fully vested membership – You don’t want anyone to try and sell membership before they actually own it. If you have any members on a vesting program, you want to make sure they are vested before anything applies. If a non vested member tries to transfer their membership interest, it should be void as they do not actually own their membership.
Sold or otherwise voluntarily transferred – A member can do more than selling their membership, they could try to give it away or place it in a trust transfer their ownership to a spouse or a child or someone else without selling it (to settle a debt). You want to make sure to generally cover the different possibilities available.
Other than to Selling Member’s individual retirement account or a legal entity created to hold interests in the company – Though there could be other exceptions (e.g. if you will allow transfers to a trust for estate planning purposes), these are the common exceptions to a voluntary transfer.
That is solely owned by the Selling Member – You want to make sure that the Selling Member does not attempt to subvert the requirements of the buy-sell agreement by transferring their interests to an entity and selling interests to the entity. The entity exception should be to give your owners options to cover their own liabilities, but not as a way to subvert the requirements of the buy-sell agreement. If you do not restrict this, you have no way of restricting the entity once it is created.
The Company and the Members – Make sure each member individually has a right to make the purchase, but also that the company can opt to purchase the membership interests. This leaves more options to those who will remain in the company of using company money if it is available or personal money to purchase the shares. This can also help to control issues of dilution that could come up by one member making the purchase but not the others.
Right of first refusal – You are trying to make sure you have some say in who holds ownership, but you are not trying to restrict your other partners ability to make money. If someone wants out, you do not really want to force them to stay in. This right of first refusal gives you the ability to choose whether or not the proposed buyer is a good fit for your company or if you would rather buy-out the member who is ready to leave and keep the company dynamic otherwise unchanged.
Purchase on the terms set forth in this section – The paragraphs that follow in this section will go on to describe how the Right of First Refusal is exercised and how the purchase price is determined. After all, what is the point of a Right of First Refusal if you do not also have a discounted price? This helps the members know where they stand and also keeps the Selling Member in check because he knows that the selling price is set at a certain price no matter what amount he can get a potential buyer to offer. This section will also describe how the members would be required to pay the purchase price. Typically, some type of financing is permitted to make the exercise of the Right of First Refusal feasible. If there is no financing option, and the members cannot afford to exercise the Right of First Refusal, there is no benefit of the restrictions in the first place.
This is how you set up the restrictions on voluntary transfer in your business. In an LLC, the restrictions on transfer are sections of the operating agreement instead of a separate agreement. In a Corporation, the buy-sell agreement is a separate agreement between the Shareholders. The reason for this is that the Operating Agreement is an agreement between the Members about how the company will operate, but the Bylaws of a Corporation are instructions on how the company is governed and do not represent an agreement between the shareholders, so it requires a separate agreement.
I will talk to you next week, unless you talk to me first 😉
P.S. Are you interested in learning more about how to draft contracts like this? Does this type of explanation make sense? Would you be more interested in a webinar? A video series? An E-Course? I would love to know your thoughts. I want to help you protect your business, but I can only help if you let me know what would work best for you. Just hit reply and let me know!