Contemporary considerations on drafting purchase and sale terms and conditions and valuation terms in company agreements for limited liability companies

Most limited liability company operating agreements contain provisions relating to the transfer of interests by the LLC members.[1] In the absence of special regulations in a company agreement, the statutory requirements apply. In privately owned companies, transfers are often severely restricted by applicable law and sometimes even prohibited entirely. LLC statutes generally allow the transfer of economic interests (i.e. the right to receive awards and distributions) but no governance rights (e.g. voting, access to information). The division of LLC interests between economic rights and governance rights can, over time, lead to the concentration of administrative powers on the person (s) who still have governance rights, even though the person (s) are only a minority of the economic interests in the GmbH currently.

To counter these tensions, company agreements often contain what are known as “buy-sell” provisions to facilitate an orderly transfer of economic interests and to ensure an appropriate level of consistency between ownership of economic interests in the LLC and its management. Sometimes these provisions are designed to mimic unrestrained market dynamics in which capital can be used efficiently and property rights can be dispensed easily. Often, however, the provisions contain cumbersome processes and ambiguous legal terms that are far from the goal of facilitating transfers at a price that “a willing buyer would pay a willing seller”.

There are five main issues an advisor should consider when designing a buy-sell policy:

  • the events that trigger buy and sell rights (including deadlocks),
  • Valuation of interest rates,
  • the form of the transaction and payment terms,
  • the means of resolving disputes relating to value, procedure, or both, and
  • tax consequences.

Triggering events. Triggering events vary widely depending on the nature of the LLC’s business. For example, service partnerships in which all members commit to devoting substantially all of their time and attention typically list buy-sell triggers that include death, disability, resignation, and retirement. On the other hand, an LLC organized solely as a passive real estate holding company under third-party management is likely to have only a very limited number of triggering events. If administrative powers (either broadly or in relation to approving material transactions) are divided in a manner that could result in a blockage, the parties may include buy-sell provisions as a method of overcoming (or lifting) the blockage.

Valuation of LLC Shares. The basis for valuing LLC shares generally falls into three categories: the market-based approach, the income-based approach, and the asset-based approach. Some agreements refer to an (apparently) objective standard such as “fair value”, “fair market value” or “book value”; and some take the additional step of describing the person responsible for making the determination (e.g., the company’s accountant, a panel of experts, or an independent valuation firm). Other agreements use a detailed formulaic approach based on a multiple of sales, profit, or both. After all, some simply relate to the value determined by an outside expert. Frequently neglected issues in a buy-sell agreement include the effects of changes in market and corporate circumstances, extraordinary events (especially those that lead to abnormal operating results), the applicability of haircuts (whether at the corporate or equity level), or the ratio of the Evaluation of the sum insured. In today’s context, for example, market conditions, company circumstances and extraordinary events resulting from the COVID-19 pandemic and its aftermath can be relevant assessment factors. Parties should also consider the impact of valuations related to a buy-sell transaction on subsequent equity-based transactions, such as the award of earnings interest or options.

Transaction structure and conditions. Buy-sell transactions can be structured as cross-purchase transactions between or between shareholders, entity-buy transactions, or a combination of both. In addition to having important tax implications, the structure of the transaction can have a significant impact on the ownership structure and resulting governance of the LLC. Under certain circumstances, transactions can be financed with insurance. In other cases, a long-term payout may be required to keep the company sound. The agreement must provide for an exemption from liabilities and other liabilities (especially those that are taken into account in the valuation of the company); and any cash waterfalls or profit sharing (with corresponding value hurdles). Finally, the parties may wish to address the possibility of a reclaim in favor of the selling shareholder in connection with a future sale or other change of control transaction that will be completed within a defined time window after the buy-sell transaction.

Dispute resolution. Buy-sell transactions often create disagreements – as to value, terms, structure, and any other issue that the parties may contest. This applies in particular if the transaction was brought about by presumed suppressive or other abusive behavior. The success of a buy-sell agreement depends heavily on the parties’ (mutual) perception of fairness and the willingness to exchange information that may be relevant to the value. To this end, the involvement of a competent neutral under precisely defined conditions can help to quickly end potentially unsolvable disputes – especially if the necessary background and qualifications of the neutral are specified in the agreement. If the parties agree on a good process in advance, they can eliminate (or at least minimize) months or years of disputes over the selection of mediators, arbitrators, reviewers, and other experts, access to information, and sharing the costs of the process. self.[2]

During the COVID-19 pandemic, courts and lawyers have increasingly relied on mediation in civil matters. Indeed, a new ABA study comments that in civil matters, many “judges, plaintiffs’ lawyers, and defense lawyers agree that mediation is the fairest way to resolve cases”.[3] In the context of company valuation disputes, mediation offers the opportunity to implement an innovative (and cost-effective) approach in which an independent valuation expert is called in by the parties to the dispute as a neutral, expert advisor to the mediator.

Tax implications. A buy-sell transaction is essentially a mini-acquisition, and like any other acquisition, the structure of the transaction determines the tax consequences for both the buyer and the seller (e.g. whether the buy-out finances pre-tax or US dollars after tax, whether the buyer receives an increase in the company’s assets or just his share of the equity acquired, etc.). The tax consequences depend on both the structure of the transaction and the tax classification of the company itself. It is possible for the parties to agree on standard terms and conditions in advance – or at least on a procedure for deviating from these conditions, as long as the parties’ post-tax position is largely retained. For partnerships that are taxed as partnerships, the agreement must include the so-called “hot assets”, the effects of debt relief, the availability of options under Section 754 and the taxation of periodic payments (especially those based on the future development of the company that is tied to subsequent employment or service obligations or has an unlimited amount). Finally, the “new” partnership assessment rules applicable for 2018 and the following years must be taken into account, as the standard release language in purchase-sale agreements can be used to shift the seller’s tax risks to the buyer before the conclusion of the transaction.

Buy-sell agreements are a challenge – especially for customers who defy the reality that nothing stays the same. For the attentive practitioner, they also offer the opportunity to create real added value, even if its effects may only be realized well into the future.

[1] Daniel J. Sheridan, Esq., Partner, Potomac Law Group, PLLC; Elizabeth Fialkowski Stieff, Esq., Associate, Venable LLP; Mario A. Richards, Esq., Associate, Latham & Watkins, LLP; and John Levitske, Senior Managing Director, Disputes & Economics – Valuation & Accounting, Ankura Consulting Group, LLC. Ankura is not a law firm and cannot provide legal advice. The topic discussed in this article was the subject of a presentation by the authors of the 2020 LLC Institute, sponsored by the ABA Business Law Section Committee on LLCs, Partnerships and Unincorporated Entities.

[2] See Who Makes the Disputed Assessment Under the Buy-Out Provision of the LLC Agreement: Arbitrator or Appraiser? in New York Business Divore (blog post, February 15, 2021)

[3] New ABA study explains why civil and criminal court cases are disappearing, January 11, 2021: https://www.americanbar.org/news/abanews/publications/youraba/2021/0111/disappearing-juries

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