Most of us know that in business it is crucial to choose your partners carefully as the success of your business (and perhaps your livelihood) depends on it. We also encourage our business owners to have frank discussions with their partners regarding the details of the partnership and all the “what ifs” that could happen, and to confirm these agreements in a written partnership agreement at the outset of the partnership.
In addition, to ensure stability and certainty in the partnership, we usually want the partners we select to abide by certain limitations on the partners ability to sell or dispose of the interest, such as requiring partners to first following agreed upon procedures, or a require “right of first refusal” in favor of the existing partners.
A frequently overlooked detail, especially for long term partnerships, is what would happen if a life changing event happened to the partner? For example, if your partner experiences a sudden death, does that mean you now have new partners that you never agreed upon (such as the spouse or children of your deceased partner)? In most cases, if an existing partner passes away without any written plan in place, the deceased partner’s interest would pass to his/her heirs (e.g. the departing partner’s spouse or children).
The departing partner’s surviving spouse or heirs will usually have no experience or interest in operating the partnership and so planning is necessary to ensure that a departing partner’s family is adequately compensated without unduly interfering with the operations of the partnership.
Without any concrete written succession plan, you may find that your new partner or the outcome resulting from a departing partner may be determined by a civil, probate or family law court which could be expensive, and even result in the dissolution of the partnership. Most partners in a business or investment want the ability to choose who their partners will be, and would not want such unpredictability, delay, and risk in the partnership.
A buy sell agreement is an agreement among partners (or shareholders) which specifies what happens to the partner’s interest in the event of a life changing event. In most cases, these agreements cover the “four D’s” being death, disability, divorce, or departure. However, it can cover any potential situation where a partner may depart including retirement, resignation, expulsion, or sale to a third party.
Occasionally people attempt to solve the succession uncertainty by setting forth provisions in their estate plan for handling or distributing their interests in a partnership. This is not recommended because (1) including these provisions in individual estate plans do not require the input of the other partners, and therefore, one of the primary goals of promoting harmony and a mutual agreement among partners is lacking, and (2) most estate plans can be amended at any time prior to death, thereby frustrating the need of the partners for absolute certainty regarding the transition of partnership interests.
A typical buy sell agreement will contain provisions whereby if one partner experiences a death, disability, divorce, or departure from the partnership, the other partners will have an automatic right to purchase their interest at agreed upon terms and price. Oftentimes, in order to avoid liquidity issues, partners can get life and/or disability insurance on each of the partners that would fund the buyout of the departing partner’s interest. Alternatively, a buy sell agreement could specify payment of the departing partner’s interest in installments over time at an agreed upon terms, but usually that is not preferred in the case of a death or disability where the family of the departing partner may be in need of an immediate lump sum.
Since the value of the business can change over time, it is recommended the buy sell agreement set forth procedures for determining the value of the business on an ongoing basis for purposes of an unexpected buyout. Agreed upon appraisers may be used for this purpose, but it can be costly and time consuming in actual application. Instead, we generally recommend that the partners meet periodically (e.g. annually) to review the agreement and update the company valuation. This helps the partners to achieve the primary goals of a buy sell agreement, to promote certainty and the orderly transition of a departing partner’s interest, while making sure that the departing partner’s family and/or next of kin are adequately compensated.
Similar to an estate plan or marital property agreement, a buy sell agreement can be as flexible and specific as the partners wish. Many partnership agreements or operating agreements include provision governing transfers of partner’s interests, but make sure that those provisions are suitable for your situation and are comprehensive enough to apply to each of the different scenarios in which the departure of a partner could cause instability, uncertainty, or interfere with the management or business of the partnership.
A well conceived buy sell agreement should assure all the partners so that they know exactly who their partners would be in the event a triggering event, but also assure the partner’s next of kin that they will be adequately compensated for their interest in the event of a tragedy. If these provisions don’t exist in your current documents, a separate buy sell agreement that supersedes contrary provisions in your existing agreements may be recommended so that the partnership operations will not be adversely affected by a life changing event from one of the partners.