Every Buddy Needs a Buy-Sell Agreement

By HBS Tuesday, December 1, 2015

buy-sell agreementPicture this: you have gone into business with your best friend. No matter how close you are, how long you have known each other and how perfectly you have put together your business plan, you must consider a business partnership a marriage.

Every spouse, and every business partner, begins the relationship with the expectation of a long and fruitful relationship, yet this can be a somewhat naïve assumption.

Therefore it is best for all parties involved if you are prepared for the possibility of an irreconcilable breakup. In the case of a marriage, this preparation is called a prenuptial agreement; in the case of a business venture, the preparation is called a buy-sell agreement or, a bit more caustically, a shotgun clause.

If you are forming a corporation with your best friend, your buy-sell agreement would typically be included in the Shareholders Agreement or the corporate bylaws; if you are forming an LLC with your best buddy, the buy-sell agreement is usually found in the LLC Operating Agreement.

While the buy-sell agreement can be customized for more than two partners, the typical agreement is between two parties. Essentially, a buy-sell agreement allows for one of the partners to offer to buy the other partner’s share of the business for a specific price. This price is set by the partner executing the clause. The other partner has the opportunity to either accept the cash offer or buy the other partner out for the exact amount.

The period of time in which the transaction is to be completed is stipulated in the buy-sell agreement ahead of time. The response time is typically short, somewhere in the neighborhood of 20 to 40 days. If you and your friend cannot effectively communicate in order to split the business fairly and hostilities are mounting on  a daily basis, then at this point it may be best to end the business (and, unfortunately and inevitably, personal) relationship as soon as possible. 

This is obviously not an ideal situation. However, if all avenues of disagreement resolution have been exhausted, the buy-sell agreement exists so that one of the partners can execute it in order to avoid the financial (not to mention emotional) distress of potentially acrimonious actions. Once the falling-out occurs, the hope is that by dividing your mutual business quickly and equitably, the business itself will not be adversely affected.

Let’s look at a specific (but hypothetical) example: two close friends open a restaurant together, each agreeing to invest $50,000 of their own money. After they form an LLC, the friends (and now business partners) are able to secure a small business loan for an additional $100,000. In their LLC’s Operating Agreement, they stipulate the equity contribution and the fact that all profits shall be shared evenly.

They also include a shotgun clause in the Operating Agreement, stipulating a 30-day response time should this clause ever need to be executed by one of the partners. Their restaurant does well at the beginning; however, business eventually flattens out.

Minor disagreements that were easily resolved when their business was successful are now more difficult to resolve. Each partner still believes the restaurant will succeed—they tell themselves it is seasonal, or perhaps there are other economic factors are affecting sales. Stress levels rise as table reservations wane. Bills are piling up but business is dipping even lower.

what is a buy-sell agreementThe partners, once best friends, reach the point where they rarely speak to one another. Tensions continue to escalate and the business begins to suffer.

The solution is clear: the former friends and current business partners need to split up; just like in an unsuccessful marriage, their problems have become too big and invasive to tackle.

Unfortunately, there are no corporate marriage counselors to assist in the reconciliation process. Finally, one of the partners offers to buy the other partner out for $60,000, per the buy-sell agreement.

Although this seems like a fair price, both partners feel the true value of the investment is worth far more. However, once the shotgun clause has been triggered, there is no going back.

The danger of the shotgun clause is that everyone’s personal financial situations are not identical and, due to the short response time of the buy-sell agreement, one partner may possess a distinct advantage.

Let’s add to our hypothetical situation: the partner executing the shotgun clause knows that the other partner has just extended himself financially by purchasing a new home, and thus cannot match the offer. This leaves the surviving partner with 100% equity in the business as well as the small business loan debt.

Since it is typically difficult to secure financing for the purpose of responding to a buy-sell agreement, the surviving partner would be in serious financial trouble. 

There are two lessons here: it is best to always carefully consider all the terms and ramifications of your buy-sell agreement, which can make your Shareholders Agreement or Operating Agreement infinitely more important (far too often this is an afterthought not given the attention it deserves). 

If you choose to include a shotgun clause, keep the Latin phrase Praemonitus, Praemunitus in mind: it means “forewarned is forearmed.” As for the second lesson? As Mario Puzo, author of the The Godfather series succinctly put it, “Friendship and money: oil and water.”


*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.

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