Collaborators in an enterprise are usually at their most enthusiastic when they first start the business. This has always been the case. It is exactly why lawyers like us repeatedly emphasize the importance of having an actual attorney draft the LLC operating agreement. Doing so ensures that all parties maintain that enthusiasm, but pair the enthusiasm with grounded expectations. The same set of principles apply to reasons why we recommend drafting a separate buy-sell agreement at the same time.
Death or Disability
By far the most talked-about reason why an LLC buy-sell agreement should be in place relates to those unexpected events like death or disability. Any experienced life insurance broker has a handful of tales that he or she is ready to tell about how the absence of such an arrangement can spell disaster for an otherwise successful company. (Key person insurance policies are good planning devices for this purpose, but not a subject of this article).
Any traditional buy-sell agreement usually provides trigger clauses that obligate the LLC (or other 50% owner) to purchase the interest of a member who is deceased or disabled to a point where they can no longer serve. The provision normally sets a timeline, along with guidelines for seteing a purchase price, and the terms of payment. As alluded to above, payment can sometimes be arranged for in the form of an insurance policy.
Creating these agreements as standalone documents from the operating agreement guarantees their enforceability as a separate contracts, and also separates the buy-sell term contingencies from normal default buyout or dissolution provisions. Without going into too much detail, default provisions are necessarily included in the operating agreement to address who becomes a member as opposed to an investor, and procedures for winding down a closing business. In addition, by laying out procedures for which a business interest can and will be purchased, the buy-sell agreement creates certainty not only for the business owners, but more importantly for the family and heirs who stand to inherit. Eliminating the possibility that an owner’s husband or wife would step into his or her spouses’ shoes upon death or disability is a sigh of relief for many owners.
Setting Realistic Expectations
Entrepreneurs, whether optimistic, realistic, or pessimistic focus on either one or both of the following two goals: 1) Ensuring that the business is successful and 2) Ensuring that the business does not fail. While it may seem that considering these possibilities addresses the entire range of possible outcomes for the enterprise, they are neglecting an important consideration: What if the business is successful, and one of the owners needs or wants to exit?
Whether for death, for disability, or simply a motivation to cash out, a business owner’s exit can be devastating to his or her co-owners. These owners need to formulate a practical strategy that anticipates such events, and addresses them in kind. If an owner’s primary asset is the business, he will need to identify a source of income that would adequately cover the cost of purchasing an exiting co-owner. Setting flexible payment terms in the buy-sell agreement may address some of the risk, but finding a suitable funding source, or at least knowing that such a source will be needed, is paramount. The process of creating this agreement
Timelines and Restrictions
Along the same lines of setting expectations, partners or multiple company owners need to discuss at the outset how long it will take for the business to mature, and when the business owners will even have the option to exit. While many businesses open operations and intend to operate indefinitely, many more can have complex investment or financing arrangements. For these arrangements, it is normally crucial that the investor or financier maintains his or her investment for some fixed period of time while the company grows. And just as often, it is crucial that he or she gets a return on investment.
Regardless of how small or large of a contribution is made in these agreements, it is always cost effective to nail down the details, in writing, early and often. The reason being, of course, that any miscommunication or unexpressed expectation over a withdrawal or payout schedule is likely to result in lengthy disagreements, if not litigation. While gentleman’s handshakes may seem honorable, memorializing the schedule and returns should therefore be a priority at the outset.
It’s Not a Plan to Fail, You’re Probably Failing to Plan
So often in our Massachusetts business law practice we encounter clients who stubbornly persist in carrying out transactions without properly flushing out the details in writing. The buy-sell agreement of an LLC is one of the most notoriously omitted among these transactions. So often the mentality behind these omissions seems to be that the parties don’t want to get adversarial before it is necessary. In a word, they see buy-sell agreements and the like as a “plan to fail.”
Of course what these parties are doing is actually failing to plan. In life as in business, we should all hope for the best but prepare for the worst. Creating and executing a buy-sell agreement is simply an extension of that philosophy. When you are ready to start a company, or if you already have, please call our office & speak with a specialized business attorney in Massachusetts to discuss the creation of an appropriate agreement for your situation.