In my previous blog post entitled Protect Your Virginia Business with a Buy-Sell Agreement, I wrote in depth about the three essential terms of a buy-sell agreement. I coined the second element as the WHO element. The WHO element asks “who has the authority to purchase the ownership interest of a departing owner?” There are two ways to structure your buy-sell agreement in this regard: (1) the other co-owner(s) purchase the departing owner’s interest (cross-purchase agreement); or (2) the business itself purchases the departing owner’s interest (redemption agreement). You must also consider whether your cross-purchase or redemption provisions are mandatory or optional.
For example, let’s take a look at Jack & Jill and their new startup company. Jack & Jill are 50/50 owners of Up the Hill, LLC. As diligent business owners, Jack & Jill executed a Buy-sell Agreement with optional cross-purchase provisions. Jack suddenly died in a freak accident involving a pail of water. Jill now has the absolute option to purchase Jack’s 50% membership interest in the company based upon a valuation method or predetermined price. If Jill does not exercise this option, Jack’s membership interest will become an asset of his estate and be distributed in accordance with Jack’s estate plan. If the scenario involved mandatory cross-purchase provisions, Jill would be required to purchase Jack’s 50% membership interest in the company.
What if Jill does not have sufficient cash resources to purchase Jack’s 50% membership interest? Frequently, co-owners will purchase life insurance policies on the life of the other owner. Jill could purchase a $250,000.00 life insurance policy on Jack’s life. Upon Jack’s death, Jill would have cash from the life insurance policy to purchase Jack’s 50% membership interest. Another option would be to draft the Buy-sell Agreement with provisions that allow Jill to purchase Jack’s 50% membership interest by signing a promissory note. Jill would make monthly payments to Jack’s estate in accordance with the terms of the promissory note.
The above scenario involves a very basic situation. Frequently, the situation is more complex involving multiple business owners with varying degrees of ownership interest. With complex situations, you will typically consider a redemption agreement or a combination of redemption and cross-purchase. Multiple factors impact whether a redemption agreement or cross-purchase agreement (with optional or mandatory provisions) is applicable to your unique situation, such as:
- Family businesses
- Multiple owners
- Insurability of the owners
- Type of business
- Future of the business