What is an LLC Buyout Agreement?
An LLC Buyout Agreement is a legally binding document that is used to ensure the smooth transition of ownership in a limited liability company (LLC) in the event of certain specified events. These events may include the unexpected death of a member, a member filing for bankruptcy, a member wishing to leave the business, or even bankruptcy. The purpose of this agreement is to protect the interests of all members by ensuring that the business continues to run efficiently and profitably, without the disruption of a forced sale to an outsider. Unless otherwise stated in the agreement, a member will not be able to sell his or her shares of the company without providing the company and the remaining members with notice . For this reason, this arrangement is sometimes referred to as a buy-sell agreement.
In addition to covering the unexpected, the purchase agreement also may define the steps to take should a member wish to leave the company. For example, what terms, if any, will the company or remaining members have to a first right of refusal to purchase the departing member’s shares? How is the sale price determined? Since the agreement is intended to resolve virtually any possible situation of a member’s departure, the agreement should address each situation specifically.
Essential Components of a Buyout Agreement
The process of creating a buyout agreement requires that you consider a number of different aspects. Here are some of the elements that any buyout agreement should include – and how those elements work:
Valuation Method
How much is a member’s interest worth? This can be determined in several different ways. You might multiply the company’s earnings by a multiple, based on a formula that you develop. Conversely, you could also have each member obtain independent valuations of the company’s worth, with a third party valuator having the final say on the matter. It’s important to understand the mechanisms of each approach before you decide which is better.
Essentially, you should choose a valuation formula that best fits your company out of the available options. For example, a multiple of earnings or sales might work for a company that’s more established, while a fair market value appraisal would be a better fit for a new LLC that is still evolving.
Payment Terms
Once the valuation itself has been established, the real work of the buyout is in setting the terms. Every buyout agreement should have specific payment terms that cover things like the method and timing of payments, so that everyone involved understands their obligations.
Buyout Triggers
In practice, buyouts are usually triggered by events of some kind. In other words, they occur for a specific reason – could be a member becoming disabled, or a member wishing to leave for personal reasons, or not fulfilling their responsibilities. Any buyout agreement should include specific triggers that will automatically start the buyout process in certain circumstances. That way, no one is left in the dark about when a buyout becomes necessary.
Types of Buyout Agreements
The types of buyouts used in buy-sell agreements typically fall into two categories: cross purchase or redemption.
In cross purchase arrangements, the owners of the business purchase the interest from the departing member. In most cases, death or disability of the owner triggers a buy-out. This is often the best option for LLCs with three or more members. Cross purchase agreements are also effective for small or family-owned LLCs that are purchasing a key employee’s interest from his estate due to a triggering event.
Redemption agreements only use the funds of the company and are appropriate where the percent interest of each owner is uniform. Keep in mind these types of agreements do not work well with minority ownership.
Cross purchase or redemption buyout agreements can be further classified into two categories: mandatory or optional.
Mandatory agreements require the business to buy the membership interest and the member to currently sell it. The current sale feature allows LLCs to retain control over the timing of the transfer of membership interest, which provides purchasing members with added bargaining power. Furthermore, the larger financial resources of the business facilitate an easier exit from the business.
Optional agreements, on the other hand, leave the current member with the option to sell at any time. A mandatory agreement is better suited for a multi-member, closely held LLC.
Crafting a Custom-Made Template
Creating an effective buyout agreement template for a limited liability company requires a careful approach to personalize the document to your specific business needs and state laws. The following steps can help you customize an LLC buyout agreement template:
- Identify the purpose of the buyout agreement. A buyout agreement can set the terms for a member leaving voluntarily, a member being forced out of the company or a member passing away. Each scenario will have different considerations and requirements by state law.
- Review your state’s laws and be sure that the buyout agreement template you are using aligns with those laws and requirements.
- Personalize the LLC buyout template to the unique needs of your business. This includes ensuring the exit provisions meet your specific requirements and giving you enough time to bring on a new member if that is necessary.
- Consult with an attorney. It is very important that you have a legal professional review and analyze your LLC buyout agreement template to ensure that it meets your specific needs, state laws and general legal requirements for such agreements. Having an attorney look over these agreements is especially important if you are drafting one with special considerations out of the ordinary, such as if you are in a state where members have a right to leave at any time.
Ultimately, it is important to understand your needs and to have outside assistance to ensure you are creating a customized and effective buyout agreement, from the likelihood of a member leaving to the exit plan upon a member’s death.
Legal Requirements and Regulations
Although it is tempting to save costs by drafting an LLC buyout agreement without legal assistance, this approach can be a costly mistake in the long run. In addition to the business purchase or sale transaction itself, there are several compliance requirements associated with member buyouts. For example, if the member is an individual, his/her executor must be involved in the buyout process. If the member is an estate or trust, a legal review may be needed to ensure that the buyout provisions do not create an adverse tax impact. If the company is a C corporation, there may be additional IRS requirements that must be complied with, while S corporations face unique problems due to unique IRS requirements.
Regardless of the business form, the buyout agreement should include the right provisions to ensure a smooth transfer of business control and ownership . The legal advice of a business attorney with LLC and S corporation experience can ensure that revisions are not needed later, which can lead to unplanned transfer taxes as well as unexpected effects on the company’s business structure or operation. This is particularly true for businesses that own shares of another business, perhaps as a consequence of a prior buyout. It is also important for the member buyout to address the LLC or corporation’s C corporation status or its election to be taxed as an S corporation, the assumed tax consequences of the purchase price and the payment terms involved, potential capital gains exclusion, a business valuation and any life insurance policies affecting the transaction.
Pitfalls to Avoid
The creation of LLC buyout agreement templates is not an uncommon activity for an ongoing business concern as they are a key component of business continuity planning. Typically, our attorneys are hired by owners of a business to create an LLC buyout agreement template to be used for both present and future member to member dissolution or transfer of ownership.
A common mistake that occurs during the drafting phase relates to the business ownership structure. Too many individuals utilize a boilerplate buyout agreement template that does not take into account the unique details of the business’ ownership structure. In doing so, flaws in the buyout agreement template may create unforeseen complications in the event of a member to member buyout. We strongly advise business owners to invest the time and resources to create a buyout agreement template that has been tailored to the specific needs of the business’ owner structure.
Another frequent mistake when creating an LLC buyout agreement template is the failure to select the proper value for the business. The amount of money a business is worth may be a point of contention, particularly when it comes time to pay out a member for the value of his or her interest in the company. As part of the drafting process, our attorneys will analyze the business as well as any associated contracts in place between various parties to determine the best way to calculate the business’ overall value.
California is a long-standing community property state. As a result, a common mistake that many business owners make during this process is failing to properly account for the fact that a spouse may have an interest in a business held by their husband or wife. Such an omission could result in a spouse claiming an ownership interest after the death of a business partner. A compliment to the buyout agreement template should include a detailed estate plan that outlines what will happen to the business after a death occurs.
There are a host of other mistakes that can occur when preparing an LLC buyout agreement template. Some examples include only identifying "legitimate" reasons for dissolution and transfer, failing to keep the buyout agreement template fresh, or identifying an unfair method of valuation. Of note, a buyout agreement template must be kept as fresh as possible and modified to reflect changes in membership and business processes. Business owners must remain vigilant with all relevant legal documents and update them as needed to ensure that future disputes are avoided.
When to Revise and Update the Agreement
Reviewing and updating the LLC buyout agreement on a regular basis ensures it remains a relevant and effective tool throughout the life of the business. As the statutory language evinces, all of the members of the company must approve of any transfer of any part of their interests, and without doing so, it would be impossible for the company to prevent a transfer from happening, and this lack of power can be devastating. Furthermore, the leverage to an unwilling member who is going through difficult times can be exploited in order to give a third party economics of a distressed sale. A buyout provision in a well-drafted Operating Agreement takes the power away from a third party or rogue member and helps the LLC maintain control of its future. In addition to changes in the membership composition , there are various business metrics that may necessitate a change to the buyout clause. For example, if a key employee or manager leaves to work for a competitor, the membership should consider increasing the payout to that member should he create a competing business out of his contacts and clients at the LLC. Any number of changes to, or terminated, contracts may make a buyout clause more or less important and it may be prudent to change the game plan accordingly.
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