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Funny Names, Serious Consequences In Buy-Sell Agreements

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Discussing buy-sell agreements with business owners, I sometimes get odd looks when I assign names to clauses they have, or don’t have, in their agreements. The owner might say, “If we’ve already set up a buy-sell agreement, why are you calling it a ‘wait-and-see’?” Or, “What do you mean I might want a ‘drag-along’ provision?” Terms anywhere from “no-sell buy-sell” to “Texas shoot-out” may sound funny, but they address serious aspects of exit planning.

An attorney doing a good job is not just pushing a buy-sell document out of a word processor. A properly drafted buy-sell agreement reflects the planning aspirations developed by the business owners and their advisor team. Provisions are typically included in the agreement that cover key contingencies, and the provisions are designed to save money or avoid litigation. And yes, some of the names for these clauses sound a little strange.

Let’s examine four of these provisions. My hope is that by being aware of these concepts you will think through the “what if” aspects for your exit plan. Have you really considered what can happen with your business if certain circumstances occur; does your buy-sell agreement adequately anticipate these contingencies; what has changed in your business that calls for modifications to your agreement?

Wait-and-See:  We review hundreds of buy-sell agreements in a year, and quite a few of these agreements have wait-and-see provisions. Although this provision may sound like glorified procrastination, the bottom line benefit of this approach is it binds the business owners to a sale while deferring the decision as to how the sale will be transacted. For example, assume three equal owners of a business want to be bound to a buy-sell agreement in the event of an owner’s death, but they are undecided as to what method will be smartest for them from a tax perspective. Should the company buy out the decedent’s stock, or should the other owners? A typical wait-and-see buy-sell would specify that upon the shareholder’s death, the business has the first option to buy some or all of the stock; then the surviving partners have the next option; and then, to the extent there is any stock remaining, the company is obligated to buy the residual stock. The owners and business are bound, but the wait-and-see provision offers flexibility. It allows the owners to make important tax and ownership decisions at the time-of-sale rather than years in advance. As long as the owners trust each other, this added flexibility is a great asset in exit planning.

Shotgun clause:  Speaking of trust between owners, it is often essential to contractually address what happens when the owners are at a deadlock as to the future of the business. For example, what happens when one owner wants out of the business and the other doesn’t? A “shotgun clause” is simply a way to protect both the leaving and remaining owner from a protracted fight over the value of the business. Let’s say two shareholders, a man and woman, are business partners, but they are worried about what might happen if one of them wants to leave. This can be covered with a shotgun clause. If the woman wants to continue the business and the man wants out, she could trigger the clause by offering to buy the shares of the other at a specific price per share. He must then either accept that offer and sell his shares, or buy her shares at that same price. You can flip the clause so that, alternatively, the triggering shareholder is the person wanting out. Either way, the logic of this approach is inescapable. The party making the offer is not going to lowball the valuation because the other party could turn around and buy the offering owner out. It’s possible the former partners won’t be on good terms after all this happens, but the shotgun clause avoids dragging the buyout into a messy court battle.

If you find “shotgun” an odd name, there are some even stranger siblings to this provision. All of them deal with how to manage a deadlock between owners of a business. Variations include clauses with these names: Russian roulette, Texas shoot-out and Dutch auction.

Drag-along provision:  So far, I’ve dealt with situations where the shareholders are equal owners. What happens when ownership interests vary? For example, what if the majority shareholder, perhaps an investor in the business, is worried about how a minority investor would affect the sale of stock? A common solution is to include a drag-along provision in the buy-sell agreement. If this sounds to you like something where an owner is forced to do something kicking and screaming, in many cases you’d be right. However, it is something the minority shareholder agrees to in advance. The provision requires that if the majority shareholder sells his stake in the business, minority owners are forced to join the deal. They have to sell their interests at the same price per share. This provision protects majority shareholders by not encumbering a sale because of a recalcitrant minority owner.

Tag-along provision:  You can probably guess where this is going. How can a minority investor be protected against the majority investor selling out? A tag-along provision forces the majority shareholder to let the minority shareholder tag-along in the sale, at the same terms and price.

There are many other provisions that can be used in a buy-sell agreement to anticipate future contingencies. Fortunately, most of these have far more mundane names. The point is that a buy-sell agreement should be unique to the circumstances of the business and its owners. You can help your exit planning team by getting the owners together and asking “what if”. The resulting legal terms in the agreement may have funny names, but they can deliver effective results.