Buy Sell Agreements – Options to Purchase
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[Farm Law editor’s note: the following piece is in draft pending academic peer review, and written as part of the series Farm Law: Owning, Managing and Transferring Farm Interests, sponsored by the North Carolina Tobacco Trust Fund Project # #583400-10363. Comments to email@example.com are welcome.]
A buy-sell agreement – when used between equity owners in a business – is a contract creating an option for one business owner to buy all or a portion of the business (which includes its assets) upon the retirement, death, divorce, or disability of another business owner. Such agreements are often found as clauses in the governing documents of business entities such as operating agreements for limited liability companies or stock purchase agreements in corporations. Sometimes they are stand-alone documents added later to an existing business by agreement of the owners.
The buy-sell agreement specifies who can buy the ownership interest, what circumstances trigger a purchase option, and how the purchase price will be set and paid, and at what interest rate. Terms of the sale and when the sale will occur are also included. Funding of the purchase can be an important consideration in drafting an agreement, and is usually accomplished with business cash flow, loans, life insurance proceeds, or through the sale of other assets.
A buy-sell agreement allows the owners of business interests to agree ahead of time how to establish the value of the company and the value of ownership interests in a mutually beneficial agreement for all owners. Such agreement helps to reduce uncertainty about what happens in the event tragedy befalls an owner, or when an owner decides to leave the business. The agreement minimizes disruptions to the business operations after an owner’s exit because the general circumstances of the exit have been contemplated ahead of time by all parties in interest. Planning for the future of a farm or forest landholding in this way assures the business’s stability and continuity and provides investment-decision stability for the purchasing owner and perhaps other key employees.
If the buy-sell agreement covers land, it manages the risk that others – such as off-farm heirs – may gain an ownership interest and have different ideas about the use or disposition (ie. sale) of the land. In this form it is sometimes used to allow other heirs to participate in the equity of the land without ultimate control over disposition.
A common form of buy-sell agreement in limited liability company can work this way: One owner suffers a triggering event, such as death, a disability, files for divorce or files for bankruptcy, or a desire to leave the business, thus exposing ownership of his or her interest to third parties not chosen by the remaining owners. The agreement requires him or her (or his or her representative) to notify the other members in a specified manner, which starts a clock on a series of options. The business itself may have the first option to purchase the business interests of the departing member. To exercise this first option, the remaining owners of the business vote under their procedure for making such decisions, binding the company to the purchase; the purchased equity is often then allocated among the remaining members. If the company passes on the first option, or a vote for company purchase fails, then a second option may become available whereby individual owners may exercise the option and purchase the interest with their own money. They absorb the interest purchased, and their share of the company grows.
In the case of death of an owner, the company may have purchased a life insurance policy on that owner, and the governing agreement may require that the company purchase the interest.
Agreements can identify future purchasers by name, which may be useful when a current user of the property – such as a successor manager of the land – needs assurance that he or she will have the resources to operate in the future, thus giving them confidence to continue investment in enterprises. Often this option is opened to the identified person’s lineal descendants where it is important to keep land in the family.
An option holder normally has no right to force the sellers to give up their property, only the right to be the first in line to buy the property if the sellers decide to put the property on the market, or if a triggering event allows the option to be exercised. Because the option holder cannot guarantee that the business interest will be put up for sale at a time where the option holder is able to cash flow the sale, the terms of valuation and purchase are usually set forth in the buy sell agreement favorable enough to allow a purchase over time, essentially requiring the departing owner to seller-finance the purchase.
In most buy-sell agreements, the ownership interest becomes the property of the purchaser upon exercise of the option according to its terms, such as making a down payment and executing a promissory note.
Sample Option Language (Voluntary Member Departure)
The language below is taken from a limited liability operating agreement, and illustrates the order of options in the event of a voluntary departure by a member. The options work in similar fashion should an unanticipated event require operation of the buy-sell agreement.
§ Departure Notice. When a Member decides to voluntarily withdraw from the Company (i.e. wishes to dispose of his Company Interest), the Departing Interest Holder shall promptly give notice (the “Departure Notice”) to the other Members and to the Company.
§ Company Option of Redemption. Following delivery of the Departure Notice, the Company, by a Majority (>50%) vote of Company Interest held by the MANAGERS, may redeem all or any part of the Departing Interest for the purchase price and upon the other terms and conditions specified §6.8 and §6.9. To exercise this option, the Company must give notice to the Departing Interest Holder, stating the Company desires to exercise the right of redemption, not later than sixty days (60) days after receiving the Departure Notice. The Company shall deliver a copy of notice exercising redemption to the Departing Interest Holder, as well as the offered price for the purchase as determined by §6.8. Upon purchase the Company shall distribute the redeemed Departing Interest pro-rata among the remaining Members (Assignees may not receive any further distribution of Company Interest above any Company Interest previously assigned).
§ Members’ Option to Purchase. If the Company does not exercise the first option or exercises the option as to only a portion of the Departing Interest, all Members have a second right of refusal to purchase all or any portion of the balance of the Departing Interest Holder’s Company Interest for the purchase price and upon the other terms and conditions specified in this Agreement. To exercise this second option, a Member must give notice to the Departing Interest Holder, stating such Member exercises the second option, not later than sixty (60) days after the termination or expiration of the preceding offer. Each Member who exercises the second option shall deliver a copy of his notice exercising the second option to the other Members. If more than one Member has exercised their second option, the Departing Interest must be allocated equally among the Members having duly exercised this second option. However, the Members exercising this second option can agree on another arrangement.
Sample Option Language: Involuntary Transfer
The language below is written to address the involuntary transfer of interests. Because ownership in closely-held companies is restricted, if an involuntary disposition can result in a transfer to persons not authorized to become owners, the the following language may apply.
§ Involuntary Transfer by Member or Assignee
§§ Notice Upon Trigger Event. If the Member is declared to be bankrupt or insolvent by any court of competent jurisdiction, or makes an assignment for the benefit of his creditors, or has any of his Company Interest attached or levied upon for payment of his debts, or is required to transfer any Company Interest by any order, judgment, or decree of any court or other adjudicatory body for any reason, whether or not related to the Member’s or Assignee’s financial condition (including but not limited to an action for divorce) (a “Triggering Event”), such Member or his or her successor in interest, as the case may be, shall give notice to the Manager(s)s of the Company. The notice must identify the Company Interest subject to transfer as a result of the Triggering Event (the “Offered Interest”).
§§ Options to Purchase. Upon such notice, the Company and Managers then have the option to purchase the Offered Interest. The “Seller” is deemed to be the “Insolvent Interest Holder” (the Member) or his or her lawful representative and successors in interest.
1) First Option: Company Redemption. Within thirty (30) days of delivery of the Departure Notice to the Company’s address of record, the Manager(s) shall vote whether to exercise a First Option to redeem (purchase) all or any part of the Departing Interest for its fair market value (as defined herein at §6.8) and upon the other terms and conditions specified in this Agreement. To exercise this option, the Manager(s) must give notice to the Departing Member, affirming that the Company desires to exercise this first option, with purchase to close before or on the Departing Member’s date of departure as stated in his Departure Notice. The Manager(s) shall deliver a copy of notice exercising option to the Members. Following purchase of the Departing Interest, the Manager(s) shall allocate said interest pro-rata among the remaining Members’ capital accounts.
2) Second Option: Member Purchase. If the Company does not exercise the first option or chooses to exercise its option as to only a portion of the Departing Interest, any Member has a second option to purchase all or any part of the Departing Member’s Company Interest for its fair market value (as defined herein at §6.8) and upon the other terms and conditions specified in this Agreement. Upon notification by the Manager(s) that the Company does not wish to exercise its first option, a Member must then give notice to the Company and the Departing Member, stating such Member exercises the second option, not later than sixty (60) days after the termination or expiration of the preceding option. Each Member who exercises the second option shall deliver a copy of his notice exercising the second option to the other Members. If more than one Member has notified their exercise of their option to purchase the Departing Interest, the portion of Departing Interest which each Member will initially have the second option to purchase is determined by allocating the Departing Interest among the Members in proportion to their current ownership interest, unless otherwise agreed among the Members desiring to exercise this second option.
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