Many family companies do not pay much attention to their buy-sell agreement. The stagnant legal document sits in the file and is rarely reviewed.
Yet, the buy-sell agreement is a critical map for the company’s future in that it outlines what shareholders should do if someone sells stock. Third-party experts often dictate those details without a lot of oversight by the people who ultimately will be affected. If this describes how the buy-sell agreement is handled in your company, you are missing a learning opportunity for shareholders and may be putting your family business at significant risk.
A buy-sell agreement is one of the most important corporate documents for a family business. One negative about being a private company is that no ready, liquid market exists for the company’s stock. Absent the family members selling the business in its entirety, which rarely happens, the buy-sell agreement is the only document that dictates the trade terms among family shareholders. Considering that the company’s stock often comprises most of the family business owner’s net worth, it is a document that each shareholder should understand intimately.
The buy-sell agreement should:
- Reflect the intent and bargain the shareholders have reached with each other. Rather than the standard language and provisions, the agreement should represent the understanding that the shareholders have reached with each other. It also should reflect the uniqueness of the family business and the family’s approach to being a shareholder. Intuitively, that means each family member should have significant input into crafting the agreement and its provisions, and should have intimate knowledge of the final document.
- Protect the company. Since the family business is at the center of any shareholder transition, the buy-sell agreement should contain provisions that protect the company for future generations. It is important to structure terms and conditions that account for a private company’s lack of access to capital and avoid situations where a shareholder transaction could negatively affect the company’s ability to operate.
- Protect the shareholders and their families. As noted, capital is not readily available to fund family transfers of stock except when a shareholder dies. Secure adequate insurance coverage to protect the family. To do so, you must know the valuation of the company’s stock so you know the amount of life insurance to acquire. An agreement that relies on an outside expert to prescribe the value of the stock after the fact creates a structural problem with your agreement that needs to be fixed.
- Provide clarity to shareholders and avoid disputes. We find that disputes arise among family members for two primary reasons when it comes to buy-sell agreements. First, if family members were not involved in the agreement’s crafting, they don’t understand it and are often surprised when a triggering event happens. Second, if key agreement provisions such as the valuation are not measured regularly using a formula spelled out in the agreement and are instead dictated by an outside party after the fact, shareholders are often surprised at a time when they are already emotionally charged. The agreement provisions should be self-contained and crafted with the shareholders’ input so they know how it affects them.
If your buy-sell agreement does not accomplish these goals, then you have a real learning opportunity for your family shareholders to take control and “own” your agreement. With the right coaching and advice on valuation, transaction structure, and legal issues, the shareholders all can participate in deciding on the valuation formula and provisions of their buy-sell agreement. The valuation formula should be calculated annually and reviewed with the shareholders so everybody is informed about the share value. Participation in this process will increase all the family shareholders’ business IQ and help them understand their company better.