Contemporary considerations for the elaboration of buy-sell and valuation provisions in company agreements of limited liability companies
Most limited liability company operating agreements contain provisions relating to the transfer of interests by the LLC members. If no special provisions are contained in a company agreement, legal requirements apply. In privately held companies, transfers are often severely restricted by law and sometimes prohibited altogether. The LLC statutes usually allow the transfer of economic interests (i.e. the right to receive awards and distributions) but no governance rights (e.g. voting rights, access to information). The division of LLC interests between economic rights and governance rights can, over time, lead to the concentration of administrative power on the person (s) who still have governance rights, even though the person (s) are only a minority of economic interests in GmbH currently.
To counteract this tension, company agreements often contain what are known as “buy-sell” provisions to facilitate an orderly transfer of economic interests and to ensure a reasonable degree of correspondence 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. Most of the time, however, the provisions contain cumbersome processes and ambiguous legal provisions that are far from the goal of enabling transfers at a price “that a willing buyer would pay a willing seller”.
There are five key 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, process, or both, and
- tax consequences.
Trigger events. Triggering events vary widely depending on the nature of the LLC’s business. For example, service partnerships, in which all members agree to devote substantially all of their time and attention, list buy and 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 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 a (seemingly) objective standard such as “fair value”, “fair 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 a third-party independent valuation firm). Other agreements use a detailed formulaic approach based on a multiple of sales, profit, or both. Finally, some simply refer to the value determined by an outside expert. Topics that are often neglected in a purchase / sale agreement include the impact of changed market and corporate circumstances, exceptional events (especially those that lead to abnormal operating results), and the applicability of haircuts (whether at the corporate or shareholder level). , or the ratio of the valuation to 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. The parties should also consider the impact of valuation determinations in a buy / sell transaction on subsequent stock-based transactions such as the granting of earnings interest or options.
Transaction structure and conditions. Buy-sell transactions can be structured as cross-purchase transactions between or between shareholders, entity purchase transactions, or a combination of both. Not only does the structure of the transaction have important tax implications, it can also have a significant impact on the ownership structure and resulting governance of the LLC. In certain circumstances, transactions can be financed with insurance. In other cases, a long-term payout may be required to ensure the soundness of the company. 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 waterfalls or profit sharing (with corresponding value hurdles). Finally, the parties may wish to address the possibility of reclaiming in favor of the selling shareholder in connection with a future sale or other change in the control transaction that will be completed within a defined window after the buy-sell transaction.
Dispute resolution. Buy-sell transactions often lead to 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 suspected suppressive or other abusive behavior. The success of a buy-sell agreement depends to a large extent 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 to a good process in advance, they can eliminate (or at least minimize) months or years of battles over the selection of mediators, arbitrators, reviewers and other experts, access to information and the apportionment of litigation costs.
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”. 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 its tax consequences for both the buyer and the seller (e.g. whether the buy-out is pre-tax financed will) or US dollars after tax, regardless of whether the buyer receives an increase in the company’s assets or just its participation in 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 contractual terms in advance – or at least on a process that deviates from these terms, as long as the parties’ post-tax position is largely retained. For companies that are taxed as partnerships, the agreement must also include 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 future performance of ) take into account 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 contracts 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 not be realized until well into the future.
 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 and Economics – Valuation and 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 Committee on LLCs, Partnerships, and Unincorporated Companies of the ABA Business Law Division.
 See Who Makes the Disputed Assessment Under the Buy-Out Provision of the LLC Agreement: Arbitrator or Appraiser? in New York Business Divorce (Blog Post, February 15, 2021)
 New ABA study explains why civil and criminal cases will disappear on January 11, 2021: https://www.americanbar.org/news/abanews/publications/youraba/2021/0111/disappearing-juries