Why Pennsylvania Business Owners Should Plan for Ownership Changes

A closely held business may operate successfully for years without confronting a serious ownership transition. But the death, disability, retirement, departure or dispute of an owner can suddenly raise difficult questions: Who can own the departing owner’s interest? Must the company or remaining owners purchase it? How will the interest be valued? Where will the purchase money come from?

A properly structured buy-sell arrangement can answer those questions before a triggering event occurs. ZwickLaw advises Pennsylvania businesses regarding formation, contracts, ownership arrangements and disputes through its business and corporate law practice.

What Is a Buy-Sell Agreement?

A buy-sell agreement is a contractual arrangement governing the transfer or purchase of an ownership interest when specified events occur. Depending on the entity and transaction, buy-sell provisions may appear in a shareholder agreement, partnership agreement, limited liability company operating agreement or a separate contract among the owners and business.

The agreement does not simply address a future sale. It can serve as an important succession, governance and dispute-prevention document.

Common Triggering Events

The events covered should reflect the particular business and its owners. Common triggers include:

• death of an owner;
• long-term or permanent disability;
• retirement;
• voluntary withdrawal or resignation;
• termination of employment when an owner also works for the business;
• bankruptcy or creditor-related events;
• divorce or attempted transfer to a spouse;
• an attempted sale or transfer to a third party; and
• specified deadlock or other events identified by the owners.

Different triggering events may appropriately produce different purchase rights, obligations or valuation rules.

Who Buys the Ownership Interest?

A buy-sell arrangement may require or permit the company itself to purchase the interest, give the remaining owners purchase rights, or use a combination of approaches. The appropriate structure depends on the type of entity, governing documents, financing, tax considerations and the owners’ objectives.

For Pennsylvania limited liability companies, the operating agreement and Pennsylvania’s statutory framework governing LLCs are particularly important. A transfer of an economic interest does not necessarily carry the same management or membership rights, so the documents should clearly address both economic ownership and governance.

How Will the Business Be Valued?

Valuation is often the most consequential provision in a buy-sell agreement. An agreement may use a periodically agreed value, a formula, an appraisal process or another defined methodology. Each approach has advantages and risks.

A fixed dollar amount that is never updated can become obsolete. A formula may not fairly reflect an unusual business. An appraisal procedure can provide flexibility but should specify how appraisers are selected, the applicable standard of value, the valuation date and how disagreements are resolved.

How Will the Purchase Price Be Paid?

Even a well-designed valuation provision can create problems if the buyer cannot fund the purchase. The agreement should address whether payment is due at closing, over time under a promissory note, through available insurance proceeds, or through another agreed mechanism. Installment purchases should address interest, security, default remedies and prepayment.

Life insurance is sometimes used to provide liquidity for a purchase triggered by an owner’s death. Insurance arrangements should be coordinated with the agreement and reviewed periodically to determine whether coverage continues to match the intended transaction.

Restrictions on Transfers to Outsiders

Closely held business owners often want control over who can become an owner. Agreements may restrict transfers, provide rights of first refusal, require consent, or create purchase options before an interest can be transferred to an outsider. These provisions should be coordinated with the entity’s governing documents rather than drafted in isolation.

Death and Estate Planning

When an owner dies, the business agreement and the owner’s estate plan should work together. A will or trust cannot necessarily override contractual restrictions or purchase obligations governing the business interest. Conversely, a buy-sell agreement that has not been coordinated with the owner’s estate plan can create unexpected results for the surviving family.

Business succession planning therefore often benefits from coordination between business counsel, estate-planning counsel, accountants and insurance professionals.

Review the Agreement as the Business Changes

A buy-sell agreement should not be signed and forgotten. Changes in ownership, business value, debt, insurance coverage, tax law or the owners’ personal circumstances may make an older agreement inconsistent with the parties’ current objectives.

Periodic review is particularly important when the agreement relies on a stated business value or insurance funding.

How should a buy-sell agreement coordinate with the operating agreement or bylaws?

The documents should be read together. A buy-sell agreement can create confusion if its transfer restrictions, voting provisions, purchase rights or definitions conflict with an LLC operating agreement, shareholder agreement, partnership agreement, bylaws or other governing document. The review should identify which document controls if provisions conflict and whether amendments to more than one document are necessary.

Should every triggering event use the same valuation?

Not necessarily. Owners may decide that death, disability, voluntary retirement, termination for cause, an unauthorized transfer or a deadlock should have different economic consequences. If different rules are intended, the agreement should state them clearly rather than leaving the parties to argue after the event about whether a discount, appraisal standard or payment schedule applies.

What should happen after a triggering event occurs?

A workable agreement should provide a process, not merely a purchase right. That process may address notice, deadlines for exercising options, access to financial information, valuation procedures, closing documents, payment mechanics, security for deferred payments and treatment of guarantees or other obligations of the departing owner.

What Happens Without a Buy-Sell Agreement?

Without an effective agreement, the parties may have to rely on the entity’s governing documents, Pennsylvania statutory law and whatever rights can be negotiated after the triggering event has already occurred. At that point, the owners, heirs and business may have materially different interests. Planning in advance can reduce uncertainty and provide a defined process when circumstances are already difficult.

Practical Buy-Sell Agreement Review Checklist

When reviewing an existing agreement, business owners should be able to identify:

• which events trigger a mandatory or optional purchase;
• who has the right or obligation to buy the interest;
• how the ownership interest will be valued and when that valuation was last updated;
• how and when the purchase price will be paid;
• whether insurance or other funding is intended to support the purchase;
• what restrictions apply to transfers to family members or third parties; and
• whether the agreement remains consistent with the owners’ current estate plans and governing documents.

If any of those answers are unclear, the agreement may benefit from review before a triggering event occurs.

Frequently Asked Questions About Pennsylvania Buy-Sell Agreements

Is a buy-sell agreement only for businesses with many owners?

No. A two-owner company can have an especially strong need for a defined succession and transfer process because the death, disability or departure of either owner can fundamentally change control of the business.

Can a buy-sell agreement require an owner to sell after employment ends?

It can if the governing documents validly create that triggering event and purchase mechanism. The agreement should clearly distinguish ownership rights from employment rights and specify whether different termination circumstances produce different valuation or payment consequences.

Should the owners update the agreed value every year?

If the agreement relies on a periodically agreed value, the owners should follow the update procedure stated in the document. A stale value can defeat the purpose of advance planning, particularly after substantial growth, acquisition, debt reduction or other changes in the business.

Related Pennsylvania Business and Estate Planning Resources

• Legal Considerations When Starting a Pennsylvania Business
• Pennsylvania Business & Corporate Law
• Pennsylvania Estate Planning

Talk With a Pennsylvania Business Attorney

ZwickLaw assists closely held businesses and their owners with formation, operating and shareholder agreements, contracts, succession planning and business disputes. Learn more about C.J. Zwick or contact ZwickLaw to discuss a business ownership or succession matter.

This article provides general information and is not legal advice. The appropriate structure depends on the entity, governing documents, ownership arrangements, tax considerations and particular facts.