Shareholder Buy-Sell Agreement

A Shareholder Buy-Sell Agreement in the United States sets out how the parties will share ownership, profits, management and liabilities of their venture.

Buy-sell agreements for US corporations are governed primarily by state corporate law. Delaware's General Corporation Law (DGCL), Title 8 of the Delaware Code, authorises restrictions on stock transfer in Section 202, providing that a transfer restriction is binding on any person with actual notice or where the restriction is conspicuously noted on the stock certificate. California Corporations Code Section 204 and New York Business Corporation Law Section 620 similarly authorise shareholder agreements that restrict share transfers and create purchase obligations. Most states follow the Revised Model Business Corporation Act (RMBCA) provisions on share transfer restrictions.

For S corporations — corporations that have elected pass-through tax treatment under Subchapter S of the Internal Revenue Code (26 U.S.C. § 1361) — buy-sell agreements serve a critical additional function: preventing inadvertent S corporation termination. An S corporation may have no more than 100 shareholders, and shareholders must be US citizens or residents, certain qualifying trusts, or estates. A buy-sell agreement that restricts transfers to ineligible shareholders (such as non-resident aliens or C corporations) prevents inadvertent S election termination, which would convert the corporation to a C corporation and trigger potentially significant tax consequences under IRC § 1362(d).

The Internal Revenue Service (IRS) has issued guidance under Revenue Ruling 59-60 and Treasury Regulation § 25.2512-2 on the valuation of closely held business interests for estate and gift tax purposes. A buy-sell agreement that establishes a purchase price methodology consistent with IRC § 2703 — meaning the price is not artificially low and the agreement was entered into for bona fide business reasons — may bind the IRS to use the agreed price for estate tax valuation purposes on a shareholder's death.

A US Shareholder Buy-Sell Agreement is needed when two or more shareholders own stock in a closely held corporation and wish to protect against the disruption that can arise when one shareholder's interest becomes available for transfer outside the existing shareholder group.

At business formation, founding shareholders of a new corporation should execute a buy-sell agreement at the same time as — or immediately after — the initial stock issuance. Early execution establishes the ground rules before any shareholder has experienced a triggering event and while all shareholders have roughly equal bargaining positions. Waiting until a triggering event (such as a shareholder's illness or desire to retire) occurs typically results in more contentious negotiations at the worst possible time.

For family businesses incorporated in states including Delaware, Texas, California, New York, and Florida, a buy-sell agreement prevents business interests from passing to in-laws through divorce or to unintended heirs through intestacy when a shareholder dies without a will. The Uniform Disposition of Community Property Rights Act, adopted in some states, and community property laws in California, Texas, Arizona, Nevada, and other community property states create particular risk that a shareholder's spouse may acquire an interest in the corporation without the other shareholders' consent.

For professional corporations — such as those formed by physicians, attorneys, accountants, or engineers under state professional corporation statutes — buy-sell agreements that restrict ownership to licensed professionals in the relevant field are required to maintain compliance with the licensing requirements that prohibit lay ownership of professional practices. California Corporations Code Section 13401.5, for example, requires medical professional corporations to be owned only by licensed physicians.

For corporations with key-person life and disability insurance — where the corporation or co-shareholders hold insurance policies on each other's lives — the buy-sell agreement is the mechanism that connects the insurance payout to the share transfer. Without a buy-sell agreement directing insurance proceeds to the purchase of shares, the proceeds may simply flow to the surviving shareholders or the corporation without any corresponding transfer of the deceased's shares.

A US Shareholder Buy-Sell Agreement must contain several essential provisions to create a binding and enforceable framework for share transfers among the shareholders of a closely held corporation.

The triggering events section defines the specific events that activate the buy-sell mechanism. Standard triggering events include: death of a shareholder; permanent disability (defined as inability to perform material duties for a continuous period, commonly 12 to 24 months, typically tied to the definition in the corporation's disability insurance policy); retirement (voluntary cessation of active participation in the business at or after a specified age); voluntary sale or transfer of shares; involuntary transfer through divorce proceedings, bankruptcy, or creditor attachment; and termination of a shareholder's employment or service relationship with the corporation. The precise definition of each triggering event affects when the agreement activates and should be drafted with specificity to avoid disputes.

The purchase obligation section specifies whether the buy-sell creates a mandatory obligation (the remaining shareholders or the corporation must purchase, and the departing shareholder or estate must sell) or an option (the remaining shareholders or the corporation have the right but not the obligation to purchase). Mandatory buy-sell provisions provide greater certainty but may strain the purchasers' cash resources; option-based provisions provide flexibility but may leave the departing shareholder unable to sell if the options are not exercised.

The valuation methodology section is the most negotiated provision in any buy-sell agreement. The agreement must specify how the purchase price will be determined at the time of the triggering event. Methods include: a fixed price per share set at the time of execution and updated annually (with a mechanism for deemed value if not updated); book value per share as shown on the most recent audited or reviewed financial statements prepared under GAAP; a capitalization of earnings formula applying a defined multiple to average EBITDA over the preceding three to five fiscal years; independent appraisal by a Certified Business Appraiser (CBA) or Accredited Senior Appraiser (ASA) applying the fair market value standard of Revenue Ruling 59-60; or a shotgun or Texas shoot-out provision allowing either party to name a price at which they will buy or sell, with the other party choosing which role to take.

The funding mechanism section addresses how the purchaser will pay the purchase price. For death-triggered buyouts, life insurance is the most common and practical funding mechanism — either cross-purchase insurance (each shareholder holds policies on the others) or entity-purchase insurance (the corporation holds policies on each shareholder). The agreement must specify which funding structure applies, the minimum insurance coverage required, and what happens if insurance proceeds are insufficient (installment payments are standard for the shortfall). For disability-triggered buyouts, disability buyout insurance riders are available from major insurers and should be referenced in the agreement.

The payment terms section specifies the purchase price payment timeline — whether payment is made in full at closing or in installments — and the interest rate, security, and default consequences applicable to installment obligations. For death-triggered buyouts funded by insurance, payment at closing or within 30 to 60 days is standard. For other triggering events, a down payment of 10% to 30% at closing with the balance paid over three to five years at the applicable federal rate (AFR) under IRC § 1274 is commonly used.

The right of first refusal section governs voluntary transfers — situations where a shareholder wants to sell their shares to a third party. The agreement should require the selling shareholder to first offer the shares to the remaining shareholders and/or the corporation at the same price and terms as the proposed third-party sale. The right of first refusal period — typically 30 to 60 days — gives the corporation and remaining shareholders an opportunity to match the third-party offer before the selling shareholder is free to transfer to the outsider.