A buy-sell agreement is one of the most important documents in any closely held business. It governs what happens to an ownership interest when a triggering event occurs, whether that event is death, disability, retirement, or, critically, divorce. For business owners throughout Houston, Sugar Land, The Woodlands, Katy, Spring, Missouri City, and Richmond, a well-crafted buy-sell agreement can be a powerful tool for protecting the business from the disruption of a co-owner’s divorce. But a poorly drafted one, or one that is applied without careful legal analysis, can create serious complications for the divorcing owner and produce outcomes that are far from equitable.
This article explains how buy-sell agreements function in the context of Texas divorce proceedings, when they protect the business and the owner, and when they become a source of conflict.
What Is a Buy-Sell Agreement?
A buy-sell agreement, sometimes called a buyout agreement or a shareholder agreement, is a binding contract among the co-owners of a business that specifies what will happen to an owner’s interest if they depart. The agreement establishes:
- Which events trigger a buyout obligation (death, disability, divorce, bankruptcy, voluntary departure, and others)
- Who has the right or obligation to purchase the departing owner’s interest (the company, the remaining co-owners, or both)
- How the purchase price will be determined (formula, appraisal, or negotiation)
- How the purchase price will be paid (lump sum, installments, with or without interest)
- How disputes about valuation or other terms will be resolved
Buy-sell agreements are typically funded by life insurance policies that provide the liquidity to purchase a deceased owner’s interest. For other triggering events, including divorce, funding must come from the business’s cash reserves, a bank line of credit, or the acquiring party’s personal resources.
When Divorce Is a Triggering Event
Many buy-sell agreements explicitly list divorce as a triggering event, giving the company or remaining co-owners the right to purchase the divorcing member’s interest. When this provision exists, it creates a situation where the business can effectively be removed from the marital estate at a price determined by the agreement rather than by a divorce court’s assessment of fair market value.
From the co-owners’ perspective, this is exactly what the provision is designed to do: prevent an unknown, potentially hostile third party from acquiring an ownership stake in their business as a result of one member’s divorce. The co-owners have a legitimate interest in controlling who their business partners are.
From the divorcing owner’s perspective, however, the buy-sell price may be dramatically lower than the business’s actual fair market value. If the buy-sell price was set using a formula, such as book value or a multiple of earnings, that was appropriate for a routine ownership transition, it may substantially understate the value of a thriving business in an active divorce proceeding.
Can a Divorce Court Override a Buy-Sell Agreement?
This is one of the most contested questions in Texas business divorce law, and the answer is nuanced. Texas courts have held that valid, arm’s-length buy-sell agreements are generally enforceable even in the context of divorce proceedings. If the agreement was legitimately negotiated among co-owners who were all represented or advised, and if the divorcing owner was a party to the agreement and bound by its terms, the court will typically respect the agreement’s buyout mechanism.
However, Texas courts have also recognized circumstances in which a buy-sell agreement price may not control the marital estate’s valuation of a business interest:
The agreement was not negotiated at arm’s length. If the buy-sell agreement was drafted or amended in anticipation of divorce, or if the divorcing owner had significantly less bargaining power than the co-owners when the agreement was executed, a court may scrutinize the formula price more carefully.
The formula produces a grossly inadequate result. Courts have the authority, in appropriate cases, to set aside contract provisions that are unconscionable. A buy-sell price that is a small fraction of true fair market value may fall into this category.
The non-owner spouse was not a party to the agreement. A buy-sell agreement binds the owner who executed it, but in a community property state, a spouse’s right in community property may not be divested by an agreement to which they were not a party without their consent.
Valuation Disputes Under Buy-Sell Agreements
Even when the buy-sell agreement is clearly applicable and enforceable, disputes often arise about how to apply its valuation formula. Common issues include:
What earnings figure to use. Buy-sell formulas based on a multiple of earnings require agreement on which earnings figure to apply: the most recent year, a trailing average, or a forward projection. The choice of earnings base can dramatically affect the resulting price.
Whether goodwill is included. Some buy-sell formulas explicitly exclude goodwill from the calculation. If the business’s value is primarily in its goodwill, an exclusion can produce a price that bears no relationship to economic reality.
Discounts for lack of control and lack of marketability. Some buy-sell formulas apply minority and marketability discounts that further reduce the formula price. Whether these discounts are appropriate in a divorce setting is a contested issue.
The reference date for the calculation. When a buy-sell formula uses book value or earnings at a specific date, identifying that date and whether it should be adjusted to reflect events since the date of separation can be a significant point of dispute.
Using Buy-Sell Agreements Proactively
For business owners who have not yet faced a divorce but want to protect their business in the event one occurs, a properly structured buy-sell agreement is a valuable planning tool. Key drafting considerations include:
- Explicitly list divorce as a triggering event with a clear definition of when the trigger is pulled
- Use a valuation method that is fair but also reflects the legitimate interests of the remaining co-owners in continuity and predictability
- Ensure that all co-owners and their spouses understand the agreement’s terms at the time it is executed
- Revisit the buy-sell agreement periodically, especially as the business grows and its value increases
- Consider including a right of first refusal that gives the company or co-owners the option to purchase at the formula price before any divorce settlement is finalized
How a Houston Divorce Lawyer Can Help
Whether you are entering a divorce with a buy-sell agreement in place or you are trying to understand how your business’s governing documents will affect your settlement, experienced legal counsel is essential. Our firm helps business owners and their spouses throughout Houston, Sugar Land, The Woodlands, Katy, Spring, Missouri City, and Richmond navigate the complex intersection of buy-sell agreements and Texas divorce law. Our business law solutions reflect our commitment to addressing the full range of business and family law issues that arise in high-net-worth divorce proceedings.
Contact our office to speak with a Houston high net worth divorce lawyer about how your buy-sell agreement may affect the outcome of your case.