Key Documents for the Farm Transition: Management and Buy-Sell Agreements

October 22, 2021 | Jennifer Harrington

Business entities can be helpful tools for transitioning a farm business to new or additional owners. When examining the consequences of having the farm in a business entity, default state law guides all transactions, unless the business’ operating agreement/articles of organization/partnership agreement or buy-sell agreement say otherwise. Together, we will call these documents “The Agreements.” For purposes of this overview, the term “management agreement” will cover the more commonly used terms such as corporate articles of organization and bylaws, LLC operating agreements, and partnership agreements.

At the most basic level, The Agreements are contracts that control the relationship between an owner, other co-owners (if any), and a business. The Agreements make explicit the rights and duties of the owners, the rules of how the business will be managed, and make it clear how and when business interests can be transferred.

Management Agreement 

Generally, a management agreement is the document that controls two important things: (1) the relationship between the business interest holder and the management of the company and (2) the distribution rights of the business interest holder.

The relationship between the individual and the management of the company is detailed in the voting section of the management agreement. From a legal perspective, there is a big difference between the default voting provisions of corporations, partnerships, and limited liability companies. However, most default provisions can be changed in the management agreement.          

A common example of the importance of voting provisions commonly occurs in LLCs. The voting terms may specify that either (1) each member gets an equal vote or (2) voting rights are determined by ownership percentage.[i]  The operating agreement may specify that a majority vote is required for a particular action. If there are three members, there is a big difference between option one and option two.

Take for example, farm operation financing. In option one, two out of three must agree for an act to happen. It would not matter if the profits/loss allocation was 60-20-20, each member’s vote would count equally. In option two, the member owning 60%, would be able to authorize any company action. If that individual wanted the LLC to increase its credit line by pledging more LLC assets, they could. They would need to follow the operating agreement and hold a meeting with the other members, but ultimately, they would be able to authorize the expansion of credit over the objection of the other owners. With option one, the two members owning 40% of the business could work together to prevent the LLC from increasing its credit line.

The above examples reflect a member-managed LLC where members of the LLC are responsible for managing the business. This is the default structure of an LLC. The operating agreement may instead, however, establish a manager-managed LLC, where one or several managers (who may or may not be members) exclusively make decisions as to the ordinary course of the business. In this case, non-manager members’ voting rights are limited to decisions outside the ordinary course of the business, such as amending the operating agreement.

Some statutory provisions cannot be altered in a management agreement. Each type of entity in each state has a statute that explains provisions that cannot be changed. For example, most states guaranty owners a right to “inspect the books”. This means they can examine the company’s official record, balance sheet, tax returns, etc. There also cannot be unreasonable restraints preventing an owner from suing the management on behalf of the company. Finally, when it comes to formal partnerships and LLCs, the statute will often require all members’ approval for mergers or conversions, if the member will hold an interest in the entity post-merger or post-conversion.  Corporations usually require “super-majority” shareholder approval for mergers or conversions.

Buy-Sell Agreement

The buy-sell agreement is a contract made among all co-owners of a business. It controls the transfer of the business interests. A buy-sell agreement can be a standalone contract or these transfer terms can be part of the management agreement. The management agreement can also contain restrictions or provisions that complement the buy-sell agreement.  There is, however, no legal requirement for a buy-sell agreement. If there is no buy-sell agreement, then the terms of a transfer are dictated by the applicable management agreement and state law.

A main purpose of the buy-sell agreement is simplification of the exiting process for any business interest holder. The agreement also affords the company and other business owners protection if unexpected financial or transfer events occur in the future. In certain circumstances, a buy-sell agreement contains conditioned purchase options to facilitate a transfer to the next generation through, for example, an installment sale.

A buy-sell agreement may be ignored if all owners agree to an alternative. Owners may change the agreement, if necessary, to allow for the alternative arrangement. Usually, this unanimous agreement alternative, however, does not require a change to the buy-sell agreement for a single transaction. [ii] Instead, the alternative transaction terms are documented in minutes of the business meeting and adopted by the owners, with signatures.

The Five Primary Components of a Buy-Sell Agreement

There are five important decisions that owners must make before their attorney can draft a proper buy-sell agreement. These include:

  1. Who can purchase?
  2. What is the timeframe?
  3. How will the price be determined?
  4. When will the agreement apply?
  5. How will the transfer be funded?

As we discuss these common questions, please remember that the buy-sell agreement can be written flexibly to accommodate many different options.

Who Can Purchase?

The first decision for owners to make is who will get a chance to purchase the business interest? The corresponding provision in the buy-sell agreement is usually called a “right of first refusal” or “purchase option.” Owners have many flexible options when drafting these provisions. For example, they could specify a second or third right of refusal or provide specific criteria for deciding who possesses the right to buy a departing owner’s interest.

It is also possible that the company and the other owners don’t want to purchase the business interest. In this case, the agreement may allow the seller to find a willing third-party buyer. In many cases, however—especially in family businesses—owners structure the agreement so that the company or another owner must buy the business interest pursuant to specific terms. An ability to get out of the business, with payment, is required to prevent oppression of minority interest holders.

What is the Timeframe?

The second decision is the timeframe of the transfer. There are two important timeframes: the purchase option timeframe and the payment timeframe. The purchase option timeframe is how long the owner or company will have to decide whether to purchase the available interest. Timeframes are usually between 30-90 days. Remember, if there are two purchase options, then the timeframe for acceptance will mostly likely double if the holder of the first option does not exercise it. The payment term timeframe should also be established in the buy-sell agreement. Depending on the goals of the owners, the terms can be buyer- or seller-friendly.

How Will the Price be Determined?

The third decision is how the price will be determined. Since the company is a private company and not available for the public to purchase, the fair market value price for the business interest can be hard to determine. Ideally, the sales price of the business will be determined annually at a company meeting where minutes are recorded. This would be done even in years when no sale is contemplated. However, since perfection is hard to obtain, a backup valuation scheme should be established.

The default valuation scheme should be either formula-based or appraisal-based. If the default is formula-based, the terms within the formula should be well defined. Terms like “book value” or “fair value” are too broad and could have multiple definitions.[iii] If the default requires an appraisal, then the agreement must specify who will pay for the appraisal and who will choose the appraiser. It also should specify what will happen if one party is unhappy with the price. The cost of three appraisals can be steep (one by buyer, one by the seller, and a third if the first two don’t agree), so it may be helpful to agree upon a different default valuation method.

When Will the Agreement Apply?

The fourth decision is when the agreement will apply. It is typical for the agreement to cover all transfers while specifying when the purchase option timeframe will begin. The reason for this broad language is so that the agreement will cover unplanned situations. These unplanned situations include divorce, unexpected disability, or individual financial troubles. If those situations arise, it may be in the best interest of the company to purchase those shares instead of having the shares subject to court jurisdiction or liquidation needs of the business owner.   

A planned transfer occurs when one owner wishes to exit the business. The buy-sell agreement can place conditions upon when an owner can be “bought out”.

The owners must also decide if the buy-sell agreement should require or allow the company to purchase the business interests of an owner when they die. If the buy-sell does not allow this to happen, the estate will be the holder of the interest initially, and the business interest will transfer according to the estate plan. 

It is also common for the management agreement to allow some transfers to occur outside of the buy-sell agreement. In this case, the new owner will only have the rights and responsibilities afforded to them in the management agreement of the business. Some common examples of these excepted transfers include those made to lineal descendent or transfers to trusts for the benefit of the owner and spouse.

A spouse is not a lineal descendent, so caution must be taken when exempting only transfers to a lineal descendent from the buy-sell provisions. Assume, for example, that Farm ABC, LLC, is owned by three siblings – Larry, Mary, and Gary.  A buy-sell allows other owners to purchase shares of a deceased owner but exempts transfers to lineal descendants. Larry passes away and gives his business interest to his son, Lenny. The buy-sell does not control, and Lenny is given the rights afforded to him under the operating agreement of Farm ABC, LLC. Gary passes away and leaves everything to his wife, Gabriella. Mary decides that she wants Gary’s portion of the business interest.  Gabriella is not a lineal descendent, so the buy-sell requirements do apply. Mary will receive the business interest, and Gabriella will receive the price agreed upon in the buy-sell agreement.

How Will the Transaction Be Funded?

The final decision is determining how to fund the transaction. There are three typical options. The first option, cash, requires specific liquidity to pay at the time of transfer. A second option, an installment note, can be an easier option for the buyer, but the seller will have to wait to receive full payment. This can sometimes be useful to the seller from an income tax perspective, but it can have undesired consequences, and the death of the seller does not accelerate the installment agreement payments. A third option, life insurance, can be expensive, and it will only work if the transfer occurs due to death or sometimes disability. If life insurance is chosen to fund the transaction, the company must ensure that premiums are paid and that solid records are maintained. The buy-sell agreement can be written to allow multiple funding methods

 

[i] “Percentage Share” means allocation of profits/loss as expressed in percentage. In corporations this concept is known as “cumulative voting”.

[ii][  A common phrase is “Unless all members/shareholders agree otherwise . . .”

[iii] For “book value”, see, Bauer v Bauer Farms, Inc., 832 N.W.2d 663 (Iowa 2013). For “fair value”, see, “Considerations for Using Buy Sell Agreements” https://www.cpajournal.com/2018/10/03/considerations-for-using-buy-sell-agreements/ Pub. Sept. 18 in CPA Journal, last accessed 1/20/22.

 

The Center for Agricultural Law and Taxation is a partner of the National Agricultural Law Center (NALC) at the University of Arkansas System Division of Agriculture, which serves as the nation’s leading source of agricultural and food law research and information. This material is provided as part of that partnership and is based upon work supported by the National Agricultural Library, Agricultural Research Service, U.S. Department of Agriculture.