What Is a Stock Redemption Agreement and Why Might I Need One?

In a public corporation, shareholders can sell company stock at the current market price at any time. However, selling shares in a privately-held corporation is more complicated because the shares cannot be sold to the general public.

Typically, shareholder agreements of a privately held business allow its shares to be sold only in certain situations. The terms of the sale are dictated by a type of buy-sell contract known as a stock redemption agreement. Stock redemption agreements should be established at the company’s founding to provide for business continuity and an orderly transfer of ownership in the event of a planned—or unplanned—contingency.

Ownership Interests in Private and Public Companies

When a company “goes public,” it offers shares for sale as part of an initial public offering (IPO). IPOs can raise capital for a company and boost its public profile. At the same time, the founders of a company that goes public lose some control over the business entity as ownership interests are watered down by additional shareholders.

Many companies never go public, however. They remain privately held and do not issue stock to outside parties. According to the Small Business Administration, there are approximately 32 million small businesses in the United States, and many of them are privately held.[1]

For small businesses with more than one owner, the owners may be actively involved in the business or passive investors. Regardless, small, privately owned businesses are much more selective than public companies about who can hold ownership shares. The reason for this is to restrict the individuals who can become owners.

Small businesses are tight-knit, and maintaining strong internal dynamics is key to successful operations. If a business does not maintain control over the transfer of its ownership interests, it could be upended if an owner leaves.

Buy-Sell Agreements and Stock Redemption Agreements

Small businesses use buy-sell agreements to avoid internal conflict and disruption when an owner leaves the company. The owner’s departure could be voluntary (e.g., to retire) or involuntary (e.g., the owner passes away or is asked by other owners to leave the business). The owner may want to sell their business shares or another owner might want to buy them out.

An owner’s voluntary or involuntary departure is commonly known as a triggering event for the sale of the owner’s share of the business pursuant to the buy-sell agreement. The buy-sell agreement is a contract that requires the departing owner’s shares to be sold to the company or to the remaining owners. The specific terms of the sale are stipulated in the buy-sell agreement. Provisions in a buy-sell agreement often include call rights, put rights, deadlock provisions, and a right of first refusal.[2] Although the specific provisions may vary depending upon the needs of the business and its owners, the purpose of a buy-sell agreement is to provide for an orderly buyout process when there is a triggering event.

A stock redemption agreement is a buy-sell agreement between a private corporation and its shareholders. The agreement stipulates that if a triggering event occurs, the company will purchase shares from the shareholder upon their exit from the company. The company uses its own funds (not the funds of the other shareholders) to satisfy its purchase obligation outlined in the stock redemption agreement—that is, the company purchases its stock back from the shareholder upon the occurrence of a triggering event. The reacquired shares have the status of treasury stock, which can be held onto, reissued, or canceled.[3]

In some cases, a stock redemption agreement provides for the company to purchase a life insurance or disability insurance policy for each shareholder that is used to purchase their shares if they die unexpectedly or become disabled. The company pays the policy premium and is the beneficiary of the insurance policy. This is called an insured stock redemption agreement.

Should My Company Have a Stock Redemption Agreement?

Without a stock redemption agreement, things can get messy if a shareholder wants or needs to suddenly leave the business. For example, if one of the shareholders in a closely held corporation dies and leaves their company shares to a family member, that family member would become a major shareholder who may have an important voice in the election of its officers and directors, even if that person has no business experience. This could place the other shareholders in a difficult position—just as difficult as if the estate of a deceased owner sold their company interests to an outsider.

Buy-sell agreements, including stock redemption agreements, not only help to restrict the ownership of the business, but they also stave off conflicts over the terms of a buyout, including price. Most buy-sell agreements contain a valuation clause within the terms of the buyout. A valuation clause specifies a method for valuing the business and what its shares are worth.

More generally, buy-sell agreements provide a plan for addressing the departure of an owner. Not having a solid, legally-binding agreement in place to address an owner’s departure could lead to conflict, litigation, and even the dissolution of the company.

Stock redemption agreements may be advisable for a business with several shareholders. Compared to a cross-purchase agreement—a similar buy-sell agreement between company stockholders—having the company be a party to the agreement may be simpler, especially in an insured stock redemption agreement.

If you are unsure whether a stock redemption agreement, a cross-purchase agreement, or a hybrid agreement with elements of both is right for your company, an experienced business attorney should be consulted. Every buy-sell agreement must contain clear language because ambiguity will undermine the intent of the agreement. Essential provisions to be addressed in the agreement include valuation, terms of repurchase, payment, and voting rights. In addition, an attorney or tax professional can advise you on any tax issues that may arise with a stock redemption.

The best time to implement buy-sell agreements is at the formation of the company. Agreements should be regularly reviewed as well to ensure they reflect any changes to the business structure and its value. To get legal help with your buy-sell agreements, please contact our office and schedule an appointment.

 

[1] Frequently Asked Questions, U.S. Small Bus. Admin. Office of Advocacy (Oct. 2020), https://cdn.advocacy.sba.gov/wp-content/uploads/2020/11/05122043/Small-Business-FAQ-2020.pdf.

[2] Hugh H. Lambert, CPA/ABV and Briana K. Wright, Considerations for Using Buy-Sell Agreements: The Advantages for Owners, Accountants, and Financial Advisors, The CPA Journal (Oct. 2018), https://www.cpajournal.com/2018/10/03/considerations-for-using-buy-sell-agreements/.

[3] Daniel Kurt, What Is Treasury Stock? Definition, How They're Used, and Example, Investopedia (Apr. 16, 2021),

https://www.investopedia.com/ask/answers/what-is-treasury-stock/.

In a public corporation, shareholders can sell company stock at the current market price at any time. However, selling shares in a privately-held corporation is more complicated because the shares cannot be sold to the general public.

Typically, shareholder agreements of a privately held business allow its shares to be sold only in certain situations. The terms of the sale are dictated by a type of buy-sell contract known as a stock redemption agreement. Stock redemption agreements should be established at the company’s founding to provide for business continuity and an orderly transfer of ownership in the event of a planned—or unplanned—contingency.

Ownership Interests in Private and Public Companies

When a company “goes public,” it offers shares for sale as part of an initial public offering (IPO). IPOs can raise capital for a company and boost its public profile. At the same time, the founders of a company that goes public lose some control over the business entity as ownership interests are watered down by additional shareholders.

Many companies never go public, however. They remain privately held and do not issue stock to outside parties. According to the Small Business Administration, there are approximately 32 million small businesses in the United States, and many of them are privately held.[1]

For small businesses with more than one owner, the owners may be actively involved in the business or passive investors. Regardless, small, privately owned businesses are much more selective than public companies about who can hold ownership shares. The reason for this is to restrict the individuals who can become owners.

Small businesses are tight-knit, and maintaining strong internal dynamics is key to successful operations. If a business does not maintain control over the transfer of its ownership interests, it could be upended if an owner leaves.

Buy-Sell Agreements and Stock Redemption Agreements

Small businesses use buy-sell agreements to avoid internal conflict and disruption when an owner leaves the company. The owner’s departure could be voluntary (e.g., to retire) or involuntary (e.g., the owner passes away or is asked by other owners to leave the business). The owner may want to sell their business shares or another owner might want to buy them out.

An owner’s voluntary or involuntary departure is commonly known as a triggering event for the sale of the owner’s share of the business pursuant to the buy-sell agreement. The buy-sell agreement is a contract that requires the departing owner’s shares to be sold to the company or to the remaining owners. The specific terms of the sale are stipulated in the buy-sell agreement. Provisions in a buy-sell agreement often include call rights, put rights, deadlock provisions, and a right of first refusal.[2] Although the specific provisions may vary depending upon the needs of the business and its owners, the purpose of a buy-sell agreement is to provide for an orderly buyout process when there is a triggering event.

A stock redemption agreement is a buy-sell agreement between a private corporation and its shareholders. The agreement stipulates that if a triggering event occurs, the company will purchase shares from the shareholder upon their exit from the company. The company uses its own funds (not the funds of the other shareholders) to satisfy its purchase obligation outlined in the stock redemption agreement—that is, the company purchases its stock back from the shareholder upon the occurrence of a triggering event. The reacquired shares have the status of treasury stock, which can be held onto, reissued, or canceled.[3]

In some cases, a stock redemption agreement provides for the company to purchase a life insurance or disability insurance policy for each shareholder that is used to purchase their shares if they die unexpectedly or become disabled. The company pays the policy premium and is the beneficiary of the insurance policy. This is called an insured stock redemption agreement.

Should My Company Have a Stock Redemption Agreement?

Without a stock redemption agreement, things can get messy if a shareholder wants or needs to suddenly leave the business. For example, if one of the shareholders in a closely held corporation dies and leaves their company shares to a family member, that family member would become a major shareholder who may have an important voice in the election of its officers and directors, even if that person has no business experience. This could place the other shareholders in a difficult position—just as difficult as if the estate of a deceased owner sold their company interests to an outsider.

Buy-sell agreements, including stock redemption agreements, not only help to restrict the ownership of the business, but they also stave off conflicts over the terms of a buyout, including price. Most buy-sell agreements contain a valuation clause within the terms of the buyout. A valuation clause specifies a method for valuing the business and what its shares are worth.

More generally, buy-sell agreements provide a plan for addressing the departure of an owner. Not having a solid, legally-binding agreement in place to address an owner’s departure could lead to conflict, litigation, and even the dissolution of the company.

Stock redemption agreements may be advisable for a business with several shareholders. Compared to a cross-purchase agreement—a similar buy-sell agreement between company stockholders—having the company be a party to the agreement may be simpler, especially in an insured stock redemption agreement.

If you are unsure whether a stock redemption agreement, a cross-purchase agreement, or a hybrid agreement with elements of both is right for your company, an experienced business attorney should be consulted. Every buy-sell agreement must contain clear language because ambiguity will undermine the intent of the agreement. Essential provisions to be addressed in the agreement include valuation, terms of repurchase, payment, and voting rights. In addition, an attorney or tax professional can advise you on any tax issues that may arise with a stock redemption.

The best time to implement buy-sell agreements is at the formation of the company. Agreements should be regularly reviewed as well to ensure they reflect any changes to the business structure and its value. To get legal help with your buy-sell agreements, please contact our office and schedule an appointment.

 

[1] Frequently Asked Questions, U.S. Small Bus. Admin. Office of Advocacy (Oct. 2020), https://cdn.advocacy.sba.gov/wp-content/uploads/2020/11/05122043/Small-Business-FAQ-2020.pdf.

[2] Hugh H. Lambert, CPA/ABV and Briana K. Wright, Considerations for Using Buy-Sell Agreements: The Advantages for Owners, Accountants, and Financial Advisors, The CPA Journal (Oct. 2018), https://www.cpajournal.com/2018/10/03/considerations-for-using-buy-sell-agreements/.

[3] Daniel Kurt, What Is Treasury Stock? Definition, How They're Used, and Example, Investopedia (Apr. 16, 2021),

https://www.investopedia.com/ask/answers/what-is-treasury-stock/.

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