Is Your Buy-Sell Agreement Fatally Flawed?

In 1789, Benjamin Franklin famously wrote in a letter to his friend that “in this world nothing can be said to be certain, expect death and taxes.” This adage is profound, but I would politely disagree with Mr. Franklin. I believe there is a third certainty: You will leave your business one day. Now, you might leave vertically with a barrel of money or horizontally on a stretcher, but you’re definitely leaving.

Some options are obviously better than others. I’ve found that most business owners prefer a departure be accomplished in an orderly manner that preserves the financial benefits of the business for family and heirs. To this end, I cannot stress enough the need to have a properly prepared shareholder, partnership, or buy-sell agreement.

Your buy-sell agreement should have provisions that address death and disability, life changing events (e.g. marriage), as well as “partner” disputes.

Of course, a partner or co-owner dispute is the most difficult part of any buy-sell agreement. The leaving partner hails the business a gold mine, while the remaining partner decries its imminent collapse.

As a result, the partners have a difficult time agreeing on price and terms.

My Solution: One Cuts, One Chooses

To avoid this problem, buy-sell agreements can have what I call a “one cuts, one chooses” provision. I’ll explain.

I have two daughters. They both always want that last brownie or slice of cake, and they can never agree on who should get it. To avoid an all-out war, I appoint one daughter the “Cutter” and the other the “Chooser.” The Cutter slices the cake into two pieces, but the Chooser picks which piece she gets.

The Cutter has the incentive to cut fairly so the two pieces are equal. With a perfect 50/50 split, there’s no size advantage to either slice. If she fails, the Chooser will grab the larger piece, and the Cutter will suffer.

I suggest a similar arrangement for buy-sell agreements when there’s a partner dispute.

Using the “one cuts, one chooses” arrangement, one partner (the Cutter) makes an offer to buy-out the other. The offer must be in writing and include the purchase price, payment terms, and any other deal provisions. The other partner (the Chooser) then has 30 days to decide to either accept the offer or to flip it.

If the Chooser accepts the offer, she’ll sell her shares (or membership interest) to the Cutter on the exact terms of the offer. If, on the other hand, the Chooser flips the offer, she has to buy the shares of the Cutter on the exact terms of the offer.

The Cutter has an incentive to be fair in the initial buy-out offer because he might be on the receiving end of the offer.

Protecting Business Value in an Owner Disagreement Buy Out

Of course, there has to be some value in the business for this process to make sense. And this value needs to be above and beyond the physical assets of the business (its furniture, fixtures, and equipment).

For most businesses, even if the value of their hard assets is fairly high, the primary value actually comes from cash flow arising from customer relationships, better known as goodwill.

To get a clear view of this value, consider this question: Would you buy “Michael Scott’s Paper Company” if you knew that Mr. Scott could set up a new shop down the road and then call your newly purchased customers to get them to switch to his new shop? Of course you wouldn’t! The problem isn’t just that Mr. Scott would be creating another competing business; it’s that he would be siphoning off your customers based on his preestablished relationships with them.

Nobody buying out a partner wants that to happen to him either.

So, to preserve the business value and its relationships with customers, I also include restrictive covenants (non-compete, non-solicitation, and non-disclosure) in the buy-sell agreement. These restrictive covenants prohibit the selling partner from competing with the business after he’s been bought out.

Between a Non-Compete and a Hard Place

What happens if the Cutter offers to buy out the Chooser for an absurdly low sum, and requires, as part of the terms of the offer, that there is a termination of the non-compete portion of the partnership agreement?

How could this situation happen? Imagine the following: You’re the “inside” partner of a company that’s worth $1,000,000. You run the back-office operations of the business, controlling operations and managing the finances.

Your partner, on the other hand, is the sales guy. He’s out of the office selling and promoting the company to get new business. The customers know him as the face of the company.

One day, the sales partner decides he no longer needs you. He thinks he can hire a manager to do your job and keep for himself the difference between the manager’s salary and your half of the profits. So, the sales partner invokes the “one cuts, one chooses” provision of your buy-sell agreement and makes you an offer to buy your 50% interest for $10,000, an incredibly low offer, with one of the conditions being a termination of the non-compete.

You’re faced with a lose-lose arrangement.

You certainly don’t want to give away $500,000 of stock for $10,000. But, if you buy his interest according to the terms of the offer, he won’t be bound by a non-compete. You know that the next day he’ll be soliciting your customers. And, because he’s the face of your company, those customers will surely go with him, rendering the company nearly worthless.

Not good for you!

The P&O Ports Florida Case

Again, this isn’t just a thought experiment. Something similar happened in a recent Florida case called P&O Ports Florida. When faced with that dilemma, the ‘Chooser’ partner filed suit to declare the offer invalid.

Fortunately, the ‘Chooser’ partner was successful in the case, and the waiver of the restrictive covenants as a condition to the purchase was held by the court to be invalid. But, there are a couple of things the court did that you want to avoid.

First, it determined the offer language was “ambiguous”—a very bad thing when it comes to negotiated contracts. This means the court decided that it should hear testimony and then determine the parties’ original intent.

Of course, what the parties “intended” years ago when they wrote the buy-sell agreement is different than what they believe today.

Most entrepreneurs want to decide what a contract means when it’s written, rather than let a judge, who has no experience with you, your partner, or your business do it as part of a lawsuit. In fact, the whole point of a contract is to make sure you know, up-front, what is going to happen without having to go to court and spend tens of thousands of dollars on attorneys’ fees.

What this means for you is that you have to be sure that your buy-sell agreement specifically states that terminating the non-compete provisions cannot be a part of the “one cuts, one chooses” offer. Otherwise, there might be nothing worth buying.

Also during the case, the offering partner tried to rescind the offer. This caused one judge to believe the case should have been closed. Had that happened, the issue would’ve remained unresolved after spending all that time and money, only to rise later on.

Letting a partner take back the offer is like trying to put the piece of the cake back together: It makes the whole process unfair because the Cutter gets to test the waters before truly committing to an offer.

Stress Testing Your Buy-Sell Agreement

So, you want to be sure that your buy-sell agreement:

• Contains “one cuts, one chooses” and restrictive covenants/non-compete provisions,
• Provides that “one cuts, one chooses” offers cannot include termination of restrictive covenants or other contract terms that drive retaining business value after a partner to partner transfer, and
• Requires that, once made, all “one cuts, one chooses” offers are final and irrevocable.

Of course, all of this assumes that you have a fully functional buy-sell agreement. For this you need to seek the advice and counsel of a qualified legal professional.