In my last post, I discussed the value of stockholders agreements, including concepts typically covered and timing considerations for putting them in place. While stockholders agreements allocate management, information, and similar rights amongst the stockholders of a corporation, a related agreement—a buy-sell agreement—details the corporation’s and its stockholders’ rights when certain triggering events occur. Buy-sell agreements put processes around these triggering events—death, disability, divorce, termination of employment, etc.—as a means of controlling who owns shares of the corporation’s stock. Typically, buy-sell agreements give rise to either optional purchase rights or mandatory purchase obligations, and which applies depends on the nature of the triggering event and the terms of the buy-sell agreement. The occurrence of a triggering event subjects the impacted stockholder’s shares to repurchase by the corporation or the other stockholders. Below, I expand on which events typically trigger optional vs. mandatory purchase rights.
Optional Purchase Events
Events typically giving rise to an option to purchase the subject stockholder’s shares are (1) termination of the subject stockholder’s employment with the corporation; and (2) involuntary transfers, such as those involving bankruptcy.
Termination of Employment
Often, the termination of a stockholder’s employment with the corporation results in an option to purchase the terminated stockholder’s shares. With early-stage companies, there is typically an expectation that stockholders (especially founders) are actively involved in growing the business. If a stockholder’s involvement terminates, the corporation often repurchases the terminated stockholder’s shares so they can be reallocated to someone who will provide those services moving forward.
When a termination of employment occurs, the corporation typically has the initial right to purchase the terminated stockholder’s shares. If the corporation does not purchase all of the stockholder’s shares, the other stockholders often have the right to purchase the shares not purchased by the corporation.
While the process described above is very typical, there is substantial variation in how the purchase price is calculated and/or paid in connection with a termination of employment. If the termination is by the corporation without “cause” or by the terminated stockholder for “good reason” (each as defined in the buy-sell agreement or an employment agreement), the purchase price is typically the full fair market value of the shares, with payment made in a single lump sum or over a short period of time after termination. If the termination is by the corporation for cause or by the terminated stockholder without good reason, the purchase price is often a fraction of fair market value and/or is paid over a longer, more company-favorable period of time.
Involuntary Transfers
Involuntary transfers—defined as a bankruptcy or other similar event impacting a stockholder—often trigger options to purchase the impacted stockholder’s shares. The process is typically similar to the process applied to a termination of employment. The purchase price applicable to an involuntary transfer varies quite a bit, but in my experience is most often set at the full fair market value.
Mandatory Purchase Events
Other events impacting a stockholder typically give rise to a mandatory repurchase process for the impacted stockholder’s shares. Most often, those events are (1) death of a stockholder; and (2) termination of a stockholder’s marital relationship.
Death of a Stockholder
The corporation is typically obligated to purchase shares owned by a deceased stockholder, as the corporation has an interest in purchasing those shares so they can be reallocated to new service providers. Purchases in connection with the death of a stockholder are often at full fair market value.
If a buy-sell agreement includes a mandatory purchase obligation in the event of the death of a stockholder, it is common for the corporation to obtain life insurance on each stockholder subject to the mandatory repurchase obligation. This minimizes any negative cash flow impact on the corporation, as the corporation would have cash available to pay the purchase price as a result of the life insurance policy. Payment terms for the mandatory purchase vary depending on the extent the life insurance policy covers the purchase price. If the policy fully covers the purchase price, the full purchase price is typically paid in a lump sum. If the policy does not fully cover the purchase price, there is typically a lump sum payment for the amount of the policy, with the remainder paid out over time. The goal is to get the beneficiaries of the deceased stockholder’s shares (often their spouse and/or children) as much cash as possible without creating a cash crunch for the corporation required to make the payment.
Termination of a Stockholder’s Marital Relationship
In the event a stockholder goes through a divorce, it is common for a buy-sell agreement to require the divorcing stockholder to purchase any shares awarded to their spouse in connection with the divorce. The corporation and non-divorcing stockholders often have secondary rights to purchase the spouse’s shares in the event the divorcing stockholder fails to carry out the purchase as required by the buy-sell agreement. The purchase price is typically set at full fair market value. A mandatory purchase obligation in the divorce context aims to prevent a potentially hostile former spouse from owning shares in the corporation, which would otherwise entitle them to voting, information and similar rights that could make operating the business more difficult.
Purchase Price Calculation
While parties to a buy-sell agreement tend to be positive when the agreement is negotiated, things can get contentious if the buy-sell agreement is triggered down the road. To minimize the potential for disputes, a buy-sell agreement should include detailed processes for calculating the purchase price in all of the above scenarios.
Purchase prices are typically determined (1) by an independent valuation firm; or (2) pursuant to a “stipulated value” set on a periodic basis, often annually. An independent valuation firm is typically agreed upon in advance to minimize the potential for a dispute, and the valuation set by the firm is final and binding on the parties. If the corporation goes the stipulated value route, the buy-sell agreement should detail the process and interval for setting the value.