Why you need a Buy-Sell Agreement for your LLC.
Updated: Jul 5, 2019
Whether you just formed a multi-member LLC or have been operating for some time, you need to give careful consideration to implementing a Buy-Sell Agreement. In a nutshell, a Buy-Sell Agreement is an agreement among the members that establishes ground rules restricting, or forcing, the sale or transfer of membership interests in the company.
It is a common misconception that a LLC's operating agreement will amicably resolve disputes among the members. When forming a LLC and establishing the footprint of your start-up, there can be a general sense of harmony among the founders and a collective vision for the company. Invariably, disputes will arise as the start-up grows, or fails to grow, and a clear set of rules that govern irresolvable disputes becomes necessary.
Business disputes among owners can be just as intense and ugly as a mudslinging divorce. Business divorces have increased in frequency over the past decade. In those situations, business owners invariably waste a substantial amount of time and financial liquidity and suffer through stress during a long protracted legal fight. Had the business owners entered into an appropriate, carefully considered, and will drafted Buy-Sell Agreement while the owners were on "good" terms, much of the drama, expense, and stress could have been avoided.
Unfortunately, you may still be thinking that there is no chance the relationship between your specific ownership group will turn south. Perhaps your co-owners are family members, or life long friends, or you have successfully existed other start-ups together. Keep in mind that there are a few all-to-common scenarios that business owners either fail or refuse to consider. This is eerily similar to issues with estate planning in that very few people are eager to plan for their death. However, I have encountered these scenarios time and time again after the relationships sour . You should carefully consider how each would impact your business under your LLC's current documents.
1. Unwanted Transfers. Consider a situation where one of members wants to transfer their membership interest to a third party who you either don't know or don't want to be a co-owner of your business. Even worse, what if the member that wants to sell their interest holds a controlling stake in the company. How can you prevent the unwanted third party from buying the membership interest?
Answer - A properly drafted Buy-Sell Agreement can protect the remaining members by providing a right a first refusal to buy out the selling member or by prohibiting transfers without the consent of the members.
2. Needed Capital. Another common situation can occur where your LLC is in need of a capital infusion. Typically this occurs through member capital contributions or by the LLC obtaining a loan. Where a loan is the chosen vehicle for raising working capital, banks typically require the personal guaranty of all the members. So what happens when a member refuses to make their capital contribution or refuses to sign a personal guaranty?
Answer - A Buy-Sell Agreement can require that all members make capital contributions or provide a personal guaranty where necessary. The requirement is usually tied to a right to buy out any member that fails to provide capital or a personal guaranty when demanded.
3. Death of a Member. If a member of your LLC dies, what will happen to their membership interest and their right to receive income and losses of the company? Many times the membership interest passes to a surviving spouse who may or may not be actively involved in the business. It could also pass to anyone that the deceased member names in their will. Are you prepared to admit that person as a co-owner of the LLC? What if they don't participate in the operation of the company and just want to sit and collect the profits allocated to their membership interest? How can you prevent the untimely death of a member from materially affecting the membership and profitability of the LLC?
Answer - A Buy-Sell Agreement can establish the price for the remaining LLC members to buy out the deceased member's interest and prevent a third-party from becoming a member. This is a good time to point out that the LLC can also plan for the death of a member by purchasing life insurance to fund the buy out and limit the financial impact of an untimely death on the LLC's bottom line.
4. Stalemate. A stalemate can occur where a LLC has two members which each control 50% of the LLC. If the members have divergent opinions regarding the direction of the LLC and both members are adamant in their position, business can grind to a halt and animosity can grow. What happens where both sides want to buy out the other side but everyone refuses?
Answer - A compulsory buy-sell mechanism can break the stalemate. When one member offers a set price to purchase the other member’s interest, that triggers the other party‘s right to purchase the offering party’s interest under the same price and terms. This is ultimately a fair way to force the transfer of a member’s shares at a fair price. The risk of a member submitting a low ball offer is eviscerated.
Obviously there are innumerable ways that a business marriage can go wrong, but these are examples of some of the most common disputes that I encounter. Each one of these problems can be avoided with a good Buy-Sell Agreement.
It is important to keep in mind that there is no one size fits all Buy Sell Agreement. While there are numerous “Templates” circulating the internet, each Buy-Sell Agreement should be customized and narrowly tailored to fit the unique needs and circumstances of a business. Quite frankly, a poorly drafted Buy-Sell Agreement can be worse that not having one at all.
The best time to implement a Buy-Sell Agreement is at the beginning of the business relationship before there are conflicts. However, it is never too late to implement a Buy-Sell Agreement as long as all the members are in agreement. While there are legal costs and time commitments required to implement a carefully considered and well drafted Buy-Sell Agreement, those costs are minimal when compared to what a business owner can incur if no agreement exists at all.
Hight Law, LLC is one of Atlanta’s premiere business law firms focused on business law, start-ups and entrepreneurs, franchises, and business disputes. We can help you create a Buy-Sell Agreement specifically tailored to protect your LLC and give you peace of mind.
Call Ted Hight at (770) 274-6132. Email Ted Hight at firstname.lastname@example.org. Or, visit us at www.hightlawllc.com
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.