Shareholder Buy-out Agreements Protect Your Company | SVA

Written by Mike Gustafson, CPA | Jun 01, 2021

What is a Shareholder Buy-Out Agreement?

If your business model is based on shareholders buying in and out of your organization, you should have shareholder buy-out agreements.

They can be called shareholders' agreements or stock agreements, but the goal is the same. The agreement outlines how shares in the corporation should be bought and sold.

When a change of shareholder occurs, the company will want to ensure that a new shareholder fits with the current shareholder's goals and visions. This control of who owns and manages the corporation is essential and makes for a smooth transition of stock ownership.

What Should Be in the Buy-Out Agreement?

The agreement outlines the who, what, why, and how of future buy-outs:

Who Can Buy Shareholder Stock?

Can an outsider buy the stock or is it limited to current shareholders? Agreements can include a first right of refusal or a right to sell stock clause that allows the other shareholders to match an outside offer. This clause is essential if your company wants to control who can become a shareholder.

What is the Pricing Structure of the Stock?

The agreement will outline how to determine the value of the stock owned by the shareholder. The contract should be specific and detail how a dispute over the valuation of stock will be handled.

Defining the stock's value is a crucial area of the agreement with pros and cons of each method. There are five commonly used methods. Those are:

1. Book Value, which calculates total assets minus total liabilities, is a simple method to determine the value using the company's balance sheet.

2. Multiple of Revenue is used for service-type companies with little book value and more focus on human capital.

3. Multiple of Earnings is a formula that includes using a multiple of a company's profit measures, such as the price-to-earnings ratio.

4. Multiple of EBITDA is a more complex calculation that uses a fixed valuation multiple but it doesn't reflect the current capital structure, profitability, growth aspects, or market conditions.

5. Non-Formula Valuation defines when a valuation, obtained by an appraiser, will occur (e.g., yearly, every three years, or at a triggering event) and uses that valuation to determine the sales price.

You now understand the who and what, so let's talk about the how.

How will the shareholder be bought out?

Buy-out terms will include details on how the stock will be purchased and the timeframe.
Will the stock purchase occur over a specific period?
Is there life insurance that pays for the buy-out upon the shareholder's death?
Will there be an opportunity for current shareholders to purchase the stock through a repurchase agreement?

You will also want to include examples of events that could trigger a buy-out. Those might include:

An interested party who wishes to purchase the shareholder's stake in the company.
The retirement, disability, death, or incapacity of the shareholder.
A divorce settlement where an ex-spouse will receive the shareholder's stock as part of the divorce agreement.
A debt resolution where shareholder stock is part of a foreclosure of the debt.

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Now it's time to update or create your buy-out agreements.

The buy-out agreement is a binding legal contract and should be handled by an outside expert. Using a team approach with an accountant and legal counsel will give you the best strategy to create your company's agreement.

Proactive planning will help avoid issues with future transitions. Because a buy-out agreement is a complex working document, it should be revisited often to make sure it still reflects the organization's needs.

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