Perils of "Fixed-Price" Buyouts in the Operating Agreement

Peter Mahler at New York Business Divorce highlights the perils of “fixed-price” style operating agreements, shareholder agreements, and other foundational agreements between business partners.*

These types of provisions generally follow a pattern:

  • The partners agree on what they think is a fair price for a buyout at the time of formation of the business.

  • The partners include a provision stating they will update the value every two years.

  • Two years pass, then four years, then six years, and the operating agreement is never updated.

  • The value of the business diverges from the carved-in-stone fixed value in the operating agreement.

  • A partner wants to retire (as in the article), or dies, and the “fixed” amount does not bear any resemblance to a “fair” value.

  • Departing partner, or departed partner’s estate, are either shortchanged or overcompensated, depending on which direction the actual value has diverged from the “fixed” price at the time of the event triggering the buyout.

The answer, in most instances, is to not use a fixed price.

Instead, Agree to a Fixed Process

A fixed process removes the need for a crystal ball.

The partners agree on a fair process for establishing buyout price(s) for various life events that we know from experience will happen over time.

Life will throw one or more curveballs:

  • A partner dies

  • A partner seeks a new challenge

  • Partners who got along no longer get along, for personal reasons

  • A partner is disabled

  • A partner gets tangled up in a (marital) divorce

  • …etc.

Sure, you might dodge all of these traps, but if your business lasts for any length of time, chances are vanishingly small that you actually will.

By establishing a fair process - among the original partners, preferably very early in the process, at a time when everyone is getting along, and prospects are bright - you or your loved ones minimize the risk of ugly, expensive, time-consuming, stress-inducing litigation.

That kind of litigation often happens at the worst of times, when terrible life events occur.

A Fair - and Lasting - Fixed Process

A lot of these headaches can be avoided by setting a fair fixed process from the start, but what does that mean?

I will touch on that another time, but if you are looking for answers, the first place I would suggest turning is Z. Christopher Mercer. He lays out a few options in his e-book, “Buy-Sell Agreements for Closely Held Family Business Owners”:

  • Single Appraiser, Select Appraiser Now, and Value Company Now

  • Single Appraiser, Select Appraiser at Trigger Event, and Value Company at Trigger Event

  • Single Appraiser, Select Appraiser Now and Value Company at Trigger Event

As of the time of this writing, Mr. Mercer is working on drafting model provisions that can be adapted as circumstances require.

He suggests signing up for his email list to be alerted when they come out, and I note that email list signup comes with a very useful “Buy-Sell Agreement Review Checklist.”

Exceptions to the Presumption Against Fixed Price

I noted that there may be exceptions to the presumption against using a fixed price.

One possible exception, off the top of my head: it might make sense for a fixed-price buyout (say, return of capital account) for an owner who gets expelled from the LLC due to substantiated intentional misconduct.

With the infinite number of issues facing any particular business, there are no doubt plenty of other examples.

But, the takeaway here stands. Learn from the litigators.

Start with a presumption against any fixed price whatsoever, and hold strong.

Test the waters - maybe circumstances do call for a fixed price, for a certain situation - but be skeptical, and, if you are intent on forging ahead, consider using one of Mr. Mercer’s suggestions for most circumstances, and make the exceptions as narrow as possible.

*All references to “partners” are in the colloquial sense, and do not refer to legal “partners” except when otherwise noted.

But First, the Operating Agreement