Excerpt from the Growth Company Guide 4.0
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Buy-Sell Agreements are the Russian roulette contracts of private company finance. They enable one shareholder to force another shareholder to sell his ownership but only by giving the other shareholder the option, instead, to purchase the initiating shareholder’s ownership. They appear most frequently in situations where two dominant shareholders own control of a privately held company. In these cases, they can provide a last-resort method of breaking a deadlock between owners who disagree over the management of a company. When they are used, they frequently appear in standalone buy-sell agreements or as part of other financing or shareholders agreements.

Buy-sell agreements typically work like this: Two shareholders agree that under certain agreed upon conditions, either may buy all of the other's stock in the company. By the terms of the agreement, whichever shareholder exercises this option must also offer to sell his stock to the other shareholder. The purchase price per share is usually the same for both shareholders but undetermined when the contract is signed. The initiating shareholder selects the price per share and makes his offer to buy. The other shareholder can then sell his stock or buy the other party’s stock at the tendered price. In this way, either shareholder can force the other out of the company but only by risking having his interest bought out instead.

Sometimes outside investors insist on buy-sell agreements with the owner-managers of companies they fund. They do so to provide a last-resort mechanism to  withdraw from a company at a later date.  With a buy-sell, an investor knows that if the owner-manager is unwilling to sell the company or assist them in obtaining liquidation, they can use the buy-sell agreement to either get their money out or get management's shares. With management's shares, they can replace management or have enough shares to sell a controlling interest in the company to others.

The risk-of-sale feature, leads many to assume these agreements are fair allocations of risk inasmuch as both parties face the same risk of being forced to sell it they try to force a sale. In practice, however, buy-sell agreements often tend to favor the investor and result in the removal of the owner-manager. This is because the agreements are usually exercised when a company is not living up to expectations. In these circumstances, it can be hard for an owner-manager to raise enough money to buy out the investor. Even when the owner-manager succeeds in raising the money, he may have to welcome a new investor into the company to raise the funds. This can reduce the manager's ownership in the company.

When management cannot raise the money it loses its stock and its control of the company. If management has given personal guarantees to secure company borrowings, not only does management lose its interest in the company, it also remains bound on its guarantees. Because many new company borrowings require guarantees, management should be sure that any buy-sell agreement it signs requires the investor to get management released from any personal guarantees it has made for the company. Otherwise, management may remain liable on its guarantees while the company's ability to repay its loans is determined by how well others manage the company.

With any buy-sell agreement, management should try to structure the agreement in ways that reduce the investor's ability to exercise the buy-sell and increase the chance that the investor, and not management, will be the party that sells. The best way to keep a buy-sell silent is to make its exercise contingent on the company failing to meet goals that are easily attainable. As long as these goals are met, the investor has no right to force a buy-sell on management. Making the purchase price lower for management can make it easier for management to buy out the investor and stay in control.

Giving management the right to use promissory notes for part of the purchase price helps too, by making it easier for management to pay for the investor's shares. So does giving management a long time in which to respond to the investor's offer. It is much easier to raise $5 million in 180 days than in 30 days. Finally, buy-sells should expire after a fixed period of time.

Factors to consider when faced with a buy-sell proposal include:

• Relative ownership. If the parties to the buy-sell do not own approximately the same number of shares, the party with the fewer shares will have to buy more shares. If the share prices are equal, this translates into a higher purchase price for the smaller party.

• Relative resources. If one party has more financial resources than the other it may prove easier for him to buy than the other party.

• Exercise prices. Should each party have to pay the same per share price? If not, what kind of discount is appropriate and for which party?

• Response time. How long does the party receiving the offer have to reply? Is the period long enough to enable him to obtain necessary funding?

• Payment method. How and when does the buying party have to pay the purchase price? Do both parties have to pay in the same way or can management pay a portion by promissory note?

• Conditions to exercise. Should there be conditions that must be met before either party can exercise their rights under the agreement. For example, should a predefined period of time expire or should their be a failure to meet a defined goal.

• Guarantees. If one party has guaranteed company notes or leases, he may want to provide for his release in case his interest is bought out.

• Substitution. Can the company substitute for management as a buyer? If it can, company resources may be used instead of management’s to buy out the investor.

• Termination.  When does the agreement terminate?

 Buy-sell agreements are also sometimes used for estate planning purposes in privately held companies. When funded by insurance, they can provide for orderly succession of ownership and liquidity for the estates of company owners when one owner dies. These buy-sell agreements, because the buy-out is funded by insurance and because the sale is triggered only by an owner's death, provide none of the potential inequities described above. Care must be taken with these agreements to provide assurances of continuing insurance coverage and mechanisms for adjusting price to reflect future values.

See: Co-Sale Agreements, Exits, First Refusal Rights (Shareholder), Liquidity Agreements, Puts, Shareholders' Agreements, Unlocking Provisions.