Buy-Sell Agreements: The Key to Low-Conflict Exits in Family Business

April 02, 2024
Setting up a proper buy-sell agreement is key to mitigating conflict when a stakeholder wants to leave the family business.

A shareholder’s decision to sell their ownership interest in the family business can elicit a profound emotional response from both the departing owner and those who will remain in the ownership group. Implementing thoughtful buy-sell terms in an operating agreement can prevent conflict and preserve family unity.

The reality is that when shareholders blow the dust off this section of their operating agreement, they often find merely a basic construct that is not suitable for the size and complexity of the business today or that it addresses only sales occurring upon death of a shareholder. The agreements typically also fail to contemplate what a “fair” process looks like when there is a desire or need to transact while everyone involved is alive and the circumstances aren’t necessarily convenient.

The consequences of waiting until a situation calls for this section of an operating agreement to find out whether it “works” can be disastrous for both businesses and families.

As an example, think of business ownership as a room with a locked door. A shareholder who wants out but lacks clear exit options may resort to drastic, irrational measures. Getting desperate, they take a proverbial sledgehammer to every wall and window around them. While they may not ultimately break through, the damage done in their effort to get out stays with everyone – both in the business and the family. It’s a common scenario, but one that can be mitigated with foresight and well-designed governing structures. Shareholders can then take comfort in knowing a door is available for people to leave the business. Those shareholders who remain will be assured that the enterprise will survive the event and that family relationships have a better chance of remaining intact.

The following steps can help relieve stress on both sides of the table.

Consider the Guiding Principles

Aligning the shareholder group at the beginning of the process can yield a rich and productive discussion around new buy-sell provisions and can further unite ownership. Here are six guiding principles to consider:

  1. Balance is key. Strive for an arrangement that strikes the delicate balance between seller and remaining shareholder interests. Getting each owner to recognize that they could be a remaining shareholder or a seller at any time is crucial. This requires the agreement to pass the empathy test: If roles were reversed, would both the seller(s) and the remaining owners feel the terms are fair? Each shareholder must consider each position, one at a time. This exercise, while important, can be difficult for many shareholders, as they typically have well-established views on whether they are a potential buyer or seller. (Some also struggle with a lack of concrete facts that might inform their position in the future.)
  2. Minimize harm to the enterprise. It is important to design the agreement to handle future changes without causing undue harm (e.g., an inability to operate or taking on a level of debt that would over-lever the business or violate a loan agreement). However, some harm may be unavoidable, such as when an owner who has a sizeable share of the company wants to leave. This is where the distinction between minimizing harm and eliminating harm is important. Based on principle No. #1 – balance and fairness – no plan should be so extreme that the seller can bankrupt the company or severely damage its operations. However, it’s equally important for a plan to hold remaining owners accountable for honoring a request by a shareholder to sell on reasonable terms and to be paid within a reasonable period.
  3. The process itself is not a catalyst. The buy-sell agreement should not be built on opportunism. If a shareholder decides to sell because of a vulnerability, and the seller then places disproportionate leverage on others, forcing everyone to sell, there is a design problem. Similarly, insisting upon deep discounts to take advantage of someone’s need to sell is problematic. Unlike arm’s-length transactions, a goal of the buy-sell agreement in family businesses is to preserve family relationships should the need arise to use the process. Using opportunistic tactics is often viewed as acting in bad faith and can cause irreparable relationship damage.
  4. Account for insufficient liquidity. An exit is not always going to be convenient. If shareholders want to reduce or sell their shares when the company is not free of debt and awash in cash, it’s appropriate to contemplate what would need to happen to make the exit possible. A good buy-sell agreement will account for this inevitability and provide a viable approach despite less-than-ideal circumstances. Often, this can be done by using installment payments with some governance on disbursements that is tied to available free cash. The agreement should have mechanisms to manage insufficient liquidity gracefully while still considering the principles of No. 2 above.
  5. Hold all parties accountable. Consider the consequences of upholding or exceeding the requirements of the prenegotiated agreement. If remaining shareholders accelerate payouts, a discount may apply. If sellers agree to extend their payouts, a premium may be offered. Conversely, if remaining shareholders do not honor their obligations, consider clear and effective remedies for sellers to ensure the issue is corrected. Sellers often must trade their rights and future economic benefit from the point at which they have sold. Adjustments to support their vulnerability are important so that there is no confusion over what is expected if/when issues arise after their rights have been relinquished.
  6. The process should produce consistent results. A scenario analysis that addresses the “tough questions” is incredibly helpful to understand the implications of a design plan. These questions include:
    • Will both the remaining shareholders and the sellers accept the design of the plan whether company performance is strong or weak?
    • If a small shareholder and a large shareholder exit separately, will the process be equitable?
    • What happens if more than one shareholder shows interest in exiting at the same time?

Understand the Environment

Take the temperature of the owners before starting to draft or revise the buy-sell agreement. The following questions can help avoid unforeseen consequences.

Is there a stigma associated with selling?

If so, why? By selling, someone may feel they are “leaving the club,” putting greater emotional burden on the process, which may then lead to irrational behavior in the design discussion. Reducing real and perceived penalties – both financial and emotional – for holding a view is essential to ensure that the buy-sell process protects mutual interests and shareholder relationships.

Identifying conversations and suggesting strategies that promote a negative stigma, and determining what it will take to neutralize that view, supports a more productive process. It may still be possible to proceed with a rewrite despite a stigma issue, but, if left unaddressed, problems will surface if/when the exercise is discussed.

Sometimes, a decision to sell is viewed by those who remain as a punitive action. The strain payouts place on the remaining shareholders can be frustrating. While discomfort can result from a share transaction, there are several unique personal reasons that shareholders may decide they need to reduce or sell all of their ownership, including:

  • Liquidity/Risk: Some shareholders may have a desire to reinvest a greater amount (or all) of the free cash flow back in the business, whereas a selling shareholder may have a greater need for cash flow for other purposes or may be less comfortable with the risk of a concentrated equity position in a private company. By reducing or selling some of their ownership interest, they can shift their capital needs to another vehicle that generates more liquidity or has less risk.
  • Value/Volatility: The growth profile of the family business may be less aggressive than the selling shareholder prefers, so they may desire a shift to alternative investments with a stronger growth profile.
  • Shareholders’ Financial Independence vs. Autonomy: Relying on a common source of wealth can work well if there is good alignment on the shareholders’ owner strategy and their personal wealth needs. However, there is very little room to address the wealth needs of those who leave substantially all their wealth invested in the family business.
  • Family Harmony: When things go right, it’s better to be similarly invested, as everyone enjoys the same benefit. But when things go wrong, conflict can ensue. For example, some family members may have more influence than others on important decisions, although everyone is wholly invested. Balancing investments to mitigate overreaction to both performance and strategy decisions can support family relationships.

Does leaving ownership mean you leave the family?

A family’s enthusiasm about ownership can overshadow its identity beyond the business. Broad family business owner groups often focus first on developing the next generation to be stewards of the business. The family identity concern is sometimes relegated to an issue to be tackled “if we ever have time.” However, investment in family identity helps owner groups make difficult decisions about the business and ownership more objectively.

Given that owners generally have a significant portion of their net worth tied up in the business, they often find it helpful to develop personal plans that can identify alignment or divergence with the business(es) owned. The personal plan should contemplate an owner’s risk tolerance, retirement objectives, estate and tax planning and even health, among other things. Personal planning is particularly important when there are multiple owners who may have divergent goals. An early discussion will bring concerns to light and enable owners to align personal goals and objectives in advance of a liquidity event.

Questions to Drive Design

The two primary design elements of a buy-sell plan are valuation and payment. Both need to be thoughtfully designed for the plan to be successful.

Valuation

The only way to truly know the value of a business is to place it on the market and solicit bids for it. In lieu of that, the two most common ways to determine value are based on expert opinion or a formula.

  • Expert Opinion: Experts can consider a variety of factors, including financial performance, business positioning, industry dynamics, future growth potential and the values of comparable companies that have been sold. This is the more comprehensive of the two approaches, but shareholders may disagree on the expert’s subjectivity, thereby creating owner conflict. If using this approach, think in advance how to handle disagreements about the expert’s findings. There are a variety of ways to do this.
  • Formula: A formula is transparent – two people can use the same accessible financial information to calculate the value of the business. Once there is agreement on the formula design, there is usually little room for dispute about the process of deriving the business value. The disadvantage of a formula is that it does not broadly consider all the factors that an expert would consider, so it can under- or overvalue the business depending upon the point in time.

Either of these methods is suitable. Which one a family chooses depends upon its preferences and interests.

Payment

An exit plan must also include provisions for how the proceeds get paid out to the seller. It is up to the owners to decide the timing and amount of the payments if the funding is to be the business. While exiting shareholders likely have a desire for liquidity sooner rather than later, the owners must balance the level of stress these payments have on the business. The payments must balance accountability to the seller to pay in a timely manner.

Benefits of an Intentional Approach

A successful buy-sell agreement is balanced, minimizes harm to the enterprise, sets value in a way that aligns with shareholder interests, holds all parties accountable, and produces consistent results. Understanding the environment and asking the right questions can help improve the exit process. The guiding principles are meant to relieve stress on both sides of the table and minimize conflict.

Reach out to our Center for Family Business if you are interested in discussing this topic further.

This article was originally published in Family Business Magazine.

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