8998 / When is a buy-sell agreement triggered? What are the differences between mandatory and optional buyout triggers?

A buy-sell agreement is triggered upon the occurrence of certain specified “triggering events.” The parties to the agreement may build one or more triggering events into their particular buy-sell agreement, depending upon the anticipated succession issues.¹ Typical triggering events include the death, loss of required professional license, retirement or disability of an owner or shareholder, or an involuntary transfer.

If the buy-sell agreement is triggered by an owner’s disability, the owners should include a definition of “disability” in the agreement to minimize disagreement between the buying and selling owners. Further, if using disability insurance to fund the agreement, the policy itself should contain a corresponding definition of disability that all parties understand.

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Planning Point: This can also be done by reference.For example, the agreement could provide that the definition of disability will be as set forth within certain specified disability insurance policies.

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This minimizes the risk that the buy-sell agreement will be triggered in the minds of the parties, but the insurance will not cover the disability that has actually occurred. Both the Uniform Probate Code and the Social Security Administration provide definitions of “disability” that may provide useful information to small business owners negotiating contract provisions.²

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Planning Point: While it may seem convenient to incorporate the definition of “disability” in a buy-sell agreement by reference to a frequently referred to government description, this approach is not always wise. For example, Section 223(d) of the Social Security Act defines disability as “inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which has lasted or can be expected to last for a continuous period of not less than 12 months.”³ While this definition may seem unequivocal, it has been the subject of litigation in a number of cases. In one case, the Plaintiff unsuccessfully argued that the position of the word “which” in the definition supported his claim that only the impairment is required to extend over the one-year period, and that this requirement does not apply to the term, “inability to engage in any substantial gainful activity.”⁴ Incorporation by reference is no substitute for precise draftsmanship.

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Buy-sell agreements are perhaps most frequently triggered by the death or retirement of a business owner in the small business context (see Q 8993 for a discussion of the motivations behind using a buy-sell agreement to plan for these triggering events).

A triggering event can be either mandatory or optional. After the triggering events have been determined, the parties must determine whether they wish to provide that occurrence of the event makes purchase mandatory, or merely creates a right or an option to purchase under the buy-sell agreement. Like any other contract, the parties have freedom to negotiate the contract terms in a buy-sell agreement in order to reflect the specific needs of the business. There are three common rights that are negotiated in the context of buy-sell agreements, including (1) mandatory purchase requirements, (2) “call”-type options and (3) “put”-type options.

As the name suggests, if the parties provide for a mandatory purchase, all parties to the agreement will be obligated to complete the sale once the triggering event has occurred.⁵

The agreement can also provide for a call-type option, under which the buyer is given the option to purchase upon the occurrence of the triggering event. In this case, if the buyer exercises the option, the selling owner is required to sell the interests.

Conversely, the agreement can provide for a “put” type option, under which the seller is given the option to sell upon the occurrence of a triggering event, and the buyer will then be required to purchase the interests.

In any of these three situations, the triggering event will be crucial to determining whether the provisions of the buy-sell agreement are activated.⁶ The parties must consider the fact that, as in any other option contract, if the rights are structured similarly to put or call options, the party giving the option will be free to exercise the option or not to exercise the option upon occurrence of the triggering event. On the other hand, the party who gave the option is bound to perform once the option is exercised within the terms of the agreement.⁷