Buy-Sell Agreements . . . 

are contracts that entitle one shareholder to force others either to buy his stock or to sell him theirs. These contracts often appear as provisions in a financing or shareholders' agreement.

Many investors insist on buy-sell agreements with the managers of companies they fund. They view these agreements as a way to help them withdraw from a company that does not live up to their expectations. With a buy-sell, investors know they can either get their money out or get management's shares. With management's shares, they can usually replace management or have enough shares to sell control of the company to others.

Buy-sell agreements usually work like this: Two or more shareholders agree that if the company fails to meet certain goals, either may buy all of the other's stock in the company. By the terms of the agreement, whichever shareholder exercises this option must first offer to sell his stock to the other shareholder. The purchase price per share is usually the same for both shareholders (although sometimes the price is slightly lower for management). In this way, either shareholder can force the other out of the company but only by risking being bought out himself.

In practice, buy-sell agreements often work to remove management. This is because they are usually exercised only when the company is not living up to expectations. In these circumstances, it can be hard for management to raise enough money to buy out the investor. Even when management succeeds in raising the money, it often does so only by selling more stock to a new investor than it purchases from the old one. This reduces management's percentage in the company.

When management cannot raise the money it loses its stock and its control of the company. If management has given personal guarantees to secure company borrowings, not only does management lose its interest in the company, it also remains bound on its guarantees. Because many new company borrowings require guarantees, management should be sure that any buy-sell agreement it signs requires the investor to get management released from any personal guarantees it has made for the company. Otherwise, management may remain liable on its guarantees while the company's ability to repay its loans is determined by how well others (that is, new management) manage the company.

Whenever a buy-sell agreement is required by an investor, management should try to structure the agreement in ways that reduce the investor's ability to exercise the buy-sell and increase the chance that the investor, and not management, will be the party that sells. The best way to keep a buy-sell silent is to make its exercise contingent on the company failing to meet goals that are easily attainable. As long as these goals are met, the investor has no right to force a buy-sell on management. Making the purchase price lower for management can discourage an investor's exercise by forcing him to give management a bargain or pay a premium himself. The lower price makes it easier for management to buy out the investor and stay in control.

Giving management the right to use promissory notes for part of the purchase price helps too, by making it easier for management to pay for the investor's shares. So does giving management a long time in which to respond to the investor's offer. It is much easier to raise $2 million in 120 days than in 30 days. Finally, buy-sells should expire if they are not exercised within a fixed period of time. The shorter the period the better.

Buy-sell agreements, when funded by insurance, are also used by company owners to provide liquidity for their estates and orderly transitions for their companies when one of the owners dies. These buy-sell agreements, because the buy-out is funded by insurance and because the sale is triggered only by an owner's death, provide none of the potential inequities described above. Care must be taken with these agreements to provide assurances of continuing insurance coverage and mechanisms for adjusting price to reflect future values. See: Co-Sale Agreements, Exits, First Refusal Rights (Shareholder), Liquidity Agreements, Puts, Shareholders' Agreements, Unlocking Provisions.