I have handled partnership and shareholder cases for several decades. In this time, the vast majority of disputes center on the transition of ownership upon death, disability or termination of employment. In approximately half the cases, there are buy-sell agreements in the governing documents. However, they are not well written and not consistent across all governing documents. Further, there is a general failure to have a mechanism to properly fund the buyout.
In most instances I’ve dealt with, the surviving shareholders/members did not see it coming. I asked Jack McCaffery and Bruce Sham, insurance professionals from Mass Mutual for information. I’ve turned to Jack & Bruce in the past for input and they pointed me to data from a 2018 Mass Mutual and Hawk Partners* survey. The survey found that nearly 50% of business owners rarely, or never, think about transitioning ownership or finding a buyer for the business upon their retirement.
Today I want to focus on:
- What is a buy-sell agreement?
- How life (or disability) insurance can fund the buyout of a deceased or incapacitated co-shareholder or partner.
- The importance of having your counsel periodically review your documents to be sure your buy-sell provision is consistent across all of your governing agreements. For example employment agreements with principals.
Your legal counsel can work closely with other professionals (such as accountants and life insurance experts) to ensure you have a transition plan in place. This plan can mitigate the risk of litigation down the road.
Buy-sell agreements come in many forms. Generally speaking, such a clause plays a central role in a partnership, closely-held corporation or limited liability company agreement. First and foremost, they are critical to facilitate the buyout of a partner’s, co-shareholder’s or co-member’s interest upon death or disability. Likewise, the buyout is facilitated upon the termination of employment of that person. Without a provision requiring a departing shareholder (or his estate) to transition ownership, this can lead to expensive and sometimes crippling disputes. Imagine waking up one day and finding out that your co-shareholder died. Then you learn that his family expects an active role in your business.
In Real Life
Here’s a real-life example from a published decision in New Jersey. The case is Hamilton, Johnston, & Co., Inc. v. Johnston, 256 N.J. Super. 657 (App. Div. 1992). In it, the parties, in a closely-held consulting corporation, had a buy-sell provision in their shareholder’s agreement. The provision required the corporation to purchase the stock of a deceased shareholder. Where the corporation was unable to do so (i.e., where a life policy had lapsed, or there was insufficient capital in the company to do so), a surviving shareholder was given the option to buy the deceased shareholder’s stock. Neither the corporation nor the surviving shareholder were able to buy out the deceased shareholder’s stock. Therefore, a requirement was the expeditious dissolution of the corporation. Even with clauses in the governing documents, because of some inconsistencies in how to value the business, a dispute between the shareholders went on for years.
A critical consideration for any business is how to fund a buyout of a departing member or shareholder. This is essential to avoid litigation or business disruption and facilitate a smooth transition. Even the best laid plans can go awry if the business or surviving shareholders do not have the funds to implement the buyout. Hence, this is where life insurance can play a vital role. Insurance provides liquid funds at precisely the right moment, in the case of the death of a shareholder or member. Or a disability policy can be built around a buy-sell to protect against the disability of a shareholder or member.
Please call me with buy-sell agreement questions or with other shareholder dispute questions.
*2018 MassMutual Business Owner Perspectives Study conducted by Hawk Partners for MassMutual.