Shareholder Agreement Triggers

When you craft your buy-sell agreement, there are basic boiler-plate inclusions which should not be ignored which will trigger one party’s right or obligation to buyout another party under the agreement. Some of the worst litigation occurs when buy-sell agreements were not crafted or crafted poorly when businesses first started. The following are some of the standard triggers which will result in a buyout of one or more of the company founders.

• Disability or death of the owner. If the owner becomes incapacitated and cannot fulfill the duties of his/her job, then usually the best option is a buyout of stock. This option helps to mitigate risk and pass on stock value to the estate in the event of untimely death. There are numerous ways to structure death and disability trigger options in buy-sell agreements all of which can be fulfilled or supplemented using some form of life insurance.
• Divorce of the owner. Without a buyout trigger, the divorce of an owner can put the company’s longevity at risk, especially if a vindictive spouse feels the need to relinquish rights in the company. It’s best to avoid drama and require a buyout trigger in the event of spousal divorce.
• Personal bankruptcy of the owner entrepreneur. Similar to divorce, getting the company—which is generally a separate entity—tied up in complex divorce proceedings can not only mean a waste of time for company management, but also can create uncertainty for company management over particular voting rights of company stock. Buyout rights effectively neutralize any potential actions against on the part of other third parties in the case of divorce and bankruptcy.
• Owner expulsion. Kicking out an owner is almost always difficult to discuss and resolve, but like a tree, it often requires removing one of the branches so the tree might survive. There is no limit to the opportunity given to a great owner-employee, but one bad apple can spoil the entire business and its profitable cash flow. Triggers like this are generally structured to include super-high majority from all voting blocks of stock. This usually means north of 75% must agree someone needs voted off the island.
• Cash out and/or retirement of an owner. Owner retirement at the time of business sale represents a huge part of what we do and perhaps the most common reason for exit from profitable business deals.

Performing owner buyouts will remain a significant aspect for business owners in various fields over the coming decade as millions of baby boomers look to sell companies. Buyouts can be as complex as you would like to make them based on the individual needs of the respective corporations. Funding owner buyouts in your organization can also prove difficult.

Why Getting the Triggers Right Matters

A buy-sell agreement is only as effective as its trigger provisions. Vague or missing triggers routinely leave co-owners without a clear path when a life event—death, disability, a contentious divorce—arrives at the worst possible moment. Courts that are asked to fill in the blanks tend to produce outcomes that none of the original owners would have chosen voluntarily.

Practitioners who work in sell-side transaction preparation regularly encounter companies where a poorly drafted buy-sell agreement clouds ownership records and delays—or kills—a deal. Buyers conduct extensive due diligence on title and shareholder agreements, and unresolved triggering events surface as material contingencies that depress valuation or require escrow holdbacks.

Valuation Methods Tied to Triggers

Triggers alone are not enough; the agreement must also specify how the departing owner’s interest will be priced. Three approaches are commonly used:

• Fixed price. Owners agree on a dollar value at signing and update it periodically (often annually). Simple to administer, but stale valuations create disputes when a trigger actually fires.
• Formula-based price. A multiple of EBITDA or book value is set in the agreement. Formulas offer objectivity but may not track fair market value over time, particularly in fast-growing or cyclical businesses.
• Appraisal. An independent third-party appraiser determines value at the time the trigger fires. This method provides the most current and defensible price but adds time and cost to an already stressful transition.

For businesses preparing for a potential transaction or structuring their buyout triggers carefully, selecting the right valuation method is as important as selecting the right triggers. A thorough due diligence process will scrutinize both the trigger language and the pricing mechanism.

Funding the Buyout When a Trigger Fires

Knowing that a buyout is required is very different from having the cash on hand to execute it. The most common funding vehicles are:

• Life insurance. Cross-purchase policies or entity-owned policies are structured so that death or permanent disability triggers an immediate cash infusion to fund the buyout.
• Installment payments. The company or remaining owners pay the departing owner over several years, typically with interest. This preserves cash flow but leaves the departing owner as a creditor of the business.
• Sinking fund or reserve account. The company sets aside cash over time specifically to fund anticipated buyout obligations.

Each funding method has different tax and cash-flow implications. Consulting qualified legal and tax advisors before finalizing an approach is strongly recommended. If you are approaching a transition and want to understand how your agreement fits into the broader deal structure, preparing your transaction documentation in advance can surface issues early.

Coordinating the Buy-Sell Agreement with the Acquisition Process

When a company is sold to a third party rather than internally, the buy-sell agreement still matters. Some agreements contain right-of-first-refusal provisions that require an owner to offer her interest to existing co-owners before accepting a third-party bid. If that process is not followed correctly, the sale can be challenged after closing.

As you review agreements between owners, also consider how those documents interact with the functions of the acquisition agreement that will govern any future third-party sale. Similarly, the non-disclosure agreement signed early in an M&A process often sets the tone for information-sharing rights that flow from ownership structure.

Frequently Asked Questions

What happens if a buy-sell agreement has no valuation method?

If the agreement is silent on valuation, the parties must either negotiate a price at the time the trigger fires—rarely a calm environment—or resort to litigation. Courts may order an appraisal, but the legal costs and delay can far exceed the cost of having addressed the issue in the original agreement.

Can a buy-sell trigger be waived by mutual agreement?

Generally yes, if all parties to the agreement consent in writing. However, this requires careful coordination with corporate counsel to ensure that waiving a trigger does not create unintended tax consequences or violate any financing covenants that reference the agreement.

How often should trigger provisions be reviewed?

At a minimum, owners should review the agreement every two to three years and after any major business event: a significant change in revenue, a new co-owner joining, a change in financing structure, or a shift in business strategy. What worked at founding may be wholly inadequate ten years later.

Does the buy-sell agreement need to be updated when a new owner joins?

Yes. New owners should be required to execute an amended or restated agreement as a condition of receiving their equity. Failing to update the agreement can leave a new owner without enforceable buyout rights—or the company without protection if a trigger fires against the new owner’s interest.