As family offices continue to increase the number of direct investments made in privately held companies, they need to have a strong understanding of buy-sell provisions in governing agreements. These provisions serve as strategic tools for managing ownership transitions, protecting capital, and minimizing disruption in connection with a family office’s investments. Whether investing as a majority owner, a co-investor, or a passive investor, a family office looking to negotiate buy-sell provisions should emphasize flexibility, valuation clarity, and control over transfer mechanisms, all of which are essential for long-term wealth preservation and risk management/mitigation.
This article will (1) explain the basic structure of typical buy-sell provisions; (2) outline certain key considerations and best practices that family offices should consider implementing when negotiating and structuring buy-sell provisions; and (3) address certain drafting considerations in connection with buy-sell provisions.
1. What is a Buy-Sell Provision?
Buy-sell provisions define the terms pursuant to which ownership interests in an investment or operating business may be bought or sold. These provisions are usually triggered by specific events, such as: (x) a partner’s death, disability, divorce, voluntary exit, or (y) a disagreement among business partners. For family offices, crafting well-thought-out and protective buy-sell provisions in transactions with co-investors, partners, or operators helps ensure control, clarity, and continuity across their diverse holdings.
When family offices invest in closely-held businesses and/or collaborate with other investors or managers, they take on long-term risks tied to potential management changes, liquidity events, and partnership dynamics. A well-negotiated buy-sell provision can help mitigate such risks by defining exit paths, outlining valuation methodologies, and control provisions in advance, all of which should help a family office in their efforts to preserve both capital and strategic flexibility.
2. Key Considerations/Best Practices for Family Offices Negotiating Buy-Sell Provisions
When negotiating buy-sell provisions, family offices should focus on negotiating certain key provisions, including the following:
triggering events;
valuation methodologies;
funding mechanisms; and
transfer restrictions.
Addressing each of these areas carefully can help align investment outcomes with a family office’s general risk profile and strategic goals.
Triggering Events
Buy-sell provisions are typically activated by one or more triggering events that are negotiated, defined and agreed upon by the parties in advance. The most common triggering events seen in buy-sell provisions are death, disability, retirement, or voluntarily exit of a manager. However, family offices may wish to expand these provisions to include additional triggering events that may be applicable to a particular investment, such as disputes among the partners, bankruptcy filings, key person departures and/or specific regulatory changes. Tailoring these provisions to match a family office’s investment goals can help add predictability and elements of control during a potentially uncertain transition phase. Additionally, clarity in defining triggering events can help parties avoid confusion, disputes, and litigation.
Valuation Methodologies
Defining and adequately describing clear valuation methodologies can help protect the family office (x) against losses in value generally and/or (y) in connection with any potential disputes related to asset value. Family offices should seek to align the valuation provisions with the economic realities of a given investment. Some common valuation approaches include fixed prices, predetermined formulas, performance-based multiples and/or third-party appraisals.
Each approach has its unique set of pros and cons. For example, fixed prices will likely require updates year-to-year but can provide the family office predictability. Meanwhile, predetermined formulas and performance-based multiples can provide investors with their preferred calculation method but may lead to issues in the event that earnings or EBITDA are inflated or deflated due to recent market swings. Finally, third-party appraisals can provide a simpler and more accurate view of the value; however, they tend to be expensive and may not be worth the cost depending on the value of the investment. As a side note, parties should always agree in advance who will cover the cost of third-party appraisal.
For portfolio companies, adding provisions for regular valuation updates can protect against price manipulation, outdated assumptions or sudden market shifts. This helps family offices avoid any surprises while providing them with the assurance they can make an informed decision on a current basis, using an accurate picture of their investment.
Funding Mechanisms
Funding mechanisms are essential to prevent parties from having to liquidate assets, unexpectedly borrow at unfavorable terms, or walk away entirely from a transaction. Family offices often negotiate the inclusion of life insurance policies, escrow arrangements, insurance-backed purchases, or staged buyouts to ensure liquidity is available when a buy-sell provision is triggered. Other mechanisms may include annuities, internal reserves or the use of promissory notes. When deciding on which funding mechanism is appropriate, family offices should ensure they will avoid depleting reserves or over-leveraging existing assets.
Transfer Restrictions
For many family offices, maintaining their preferred level of control is often a key priority, especially if long-term or multigenerational interests in an investment are at the top of their minds. While the goal of a buy-sell provision is to restrict transferability when a triggering event occurs, family offices should ensure that buy-sell provisions always outline who can and cannot acquire interests.
Common approaches to transfer and control restrictions include rights of first refusal and similar veto rights over purchases by outside investors. Transfer restrictions should help ensure that ownership remains with the family office (or with trusted partners) and can help avoid unwanted dilution, misalignment, or governance disruption. Additionally, control provisions should align with the family office’s general governance strategy, including board composition and voting rights.
3. Drafting Considerations
In order to effectively and accurately negotiate and draft the buy-sell provisions discussed above, family offices should prioritize legal and financial due diligence. Obtaining a comprehensive picture of their investment should help provide a family office with the ability to structure buy-sell provisions in a way that maximizes flexibility in connection with an investment. Adding built-in flexibility for future reinvestment or sale allows the family office to pivot or reinvest proceeds in aligned opportunities. For example, family offices may add reinvestment rights or drag-along provisions or potentially work with co-investors to make sure these provisions align with everyone’s vision.
In addition, it is essential that a buy-sell provision supports the family office’s broader goals and decision-making structure. Further, as these goals evolve over time, buy-sell provisions previously agreed to should be reviewed periodically to help the family office determine if the provisions (x) still align with the family office’s overall investment strategy and (y) comply with any applicable legal and/or regulatory developments.
4. Conclusion
Buy-sell provisions and family office investment goals are constantly evolving. It is imperative for a family office to assess any buy-sell provisions in existing documentation to ensure that they are consistent with the family office’s objectives. A periodic review of all buy-sell provisions applicable to a family office investment should help ensure that such provisions continue to make sense in light of any changes and align with the investment goals of the family office.
If you have any questions about the topics covered in this article, please contact Yehuda M. Braunstein (Partner), Head of Family Office Practice, at ybraunstein@sadis.com or (212) 573-8029.
