What is a Redemption Agreement?
A redemption agreement, sometimes called a buyout agreement, is part of a contract between co-owners, often shareholders or partners, that sets forth how an owner or owners may sell their equity ownership interest back to the company at a certain price and according to a particular formula. There are several different types of redemption agreements, including a cross purchase agreement, a stock redemption agreement and an asset redemption agreement. Oftentimes, these agreements are used by small businesses to describe what exactly will happen at different triggering event. Triggering events are usually a death or disability of one of the company’s owners.
A redemption agreement can be useful in a business context in two primary situations. First, in a closely held company, the other owners would have no desire to continue doing business with the personal representative or heirs of a shareholder. If a shareholder dies, the remaining owners could find themselves subject to a claim from the decedent’s estate against a company that may not have been fairly compensated for the decedent’s interest. Similarly, in a situation where a shareholder or other owner goes through a divorce, its likely that the spouse will demand a portion of the company’s value during a divorce and possibly utilize that stock as collateral, thus complicating the business . A redemption agreement, in either of these cases, would provide the remaining owners the right to redeem the shares pursuant to the terms of the agreement.
In addition to redemption agreements, there is a second type of agreement that is very similar called a buy-sell agreement, which provides the right to a third party to purchase the stock at a certain time, under a certain set of conditions and for a specific price. It’s also often used in the business context in the same situations. In other words, a redemption agreement is essentially a buy-sell agreement, just in a different structure.
An example of a redemption agreement would be the following: Shareholder A has 60% and Shareholder B has 40%. Shareholder C passes away. The other shareholders have the option to purchase Shareholder C’s shares for a price to be determined pursuant to a formula that is included in the agreement. Shareholders A and B can agree to purchase Shareholder C’s stock on a prorata basis, with Shareholder A purchasing 60% of Shareholder C’s stock and Shareholder B purchasing 40% of it, unless they agree otherwise. If Shareholders A and B can not agree on a proration, the sale is made on a strictly equal basis so that both are required to purchase 50% of Shareholder C stock. Once the price is set, payment is made within 30 days of the passage of the triggering event.
Key Components of a Redemption Agreement
Like every agreement, a redemption agreement is a contract. For the purposes of the law, it achieves its validity based on the principles of offer and acceptance. In addition to the offer and acceptance, other elements commonly found in a redemption agreement include:
Parties: A redemption agreement will need to contain the names of all parties involved in the respective buy out of shares.
Terms: It will also need to contain the terms of the shares, such as common or preferred, voting rights, number of shares, or number of units.
Conditions: Like other contracts, certain conditions will need to be met for a redemption agreement to be valid. This means that a redemption agreement would need provisions that address whether the agreement needs to go through any third party approvals. For example, does the agreement need any third party approvals such as court approval or approval of the corporation’s directors?
Rights/Obligations under the Agreement: Apart from the share buyout, your redemption agreement should also contain information on your rights and obligations under the agreement. For example, could the parties involve carry out a portion of the business after the redemption takes place? Would the parties be able to take advantage of any intellectual property after the redemption? Or would the parties need to assign the rights over such intellectual property to the other? What happens if the redemptor (the party seeking to redeem) leaves out any outstanding conditions before closing of the deal? What remedies will the parties have?
Types of Redemption Agreements
The most commonly utilized redemption agreement is one that specifically provides for the repurchase of an individual shareholder’s interest. Such agreements are typically set forth in a contract, which may be in the form of a buy-sell agreement, stock option plan or some other type of similar form of agreement. In the case of a corporation, the buy-sell agreement might specifically set forth the terms, including the terms of the write-down, the valuation, payment terms and mechanisms, etc. A stock option plan, on the other hand, may simply have a brief provision permitting the corporation to repurchase the stock issued to a shareholder within a specific period of time after the corporation has been dissolved.
Sometimes, however, redemption agreements take the form of provisions found in employment agreements, restricted stock agreements or other similar agreements. These agreements, however, generally have the same effect as a buy-sell agreement because they set forth the parties’ obligations to repurchase the shareholder’s stock in the event of the occurrence of a specified event, such as death, disability, sale or termination of employment.
The next most common form of redemption agreement is one that provides for the payment of a certain amount to the estate of a past shareholder in the event of his or her death. Many closely-held corporations contain provisions in the articles of incorporation, bylaws and/or shareholder agreements that provide for the redemption of the stock of a deceased shareholder from his or her estate. If the corporation itself is not able to apply the provisions contained in those documents in order to redeem the stock of the deceased shareholder, it may use a redemption agreement to satisfy its obligations under other observed agreements.
Redemption agreements can vary among corporations in regard to their specific terms and forms. A corporation might use different forms for redemption agreements based upon whether the shareholder is living or has died. The focus of this article is upon the use of these agreements for the repurchase of the stock of a deceased shareholder.
Legal Considerations in Redemption Agreements
A critical aspect of any corporate redemption agreement is careful consideration to the various legal requirements that apply to the specific structure of that agreement. The redemption of shares by an issuer must be done in conformity with existing securities laws and common law principles relating to distributions. Redemption of preferred equity involves nuances related to acceptable dividends, asset valuations, and timing requirements for conversion of securities. Corporate bylaws often have specific requirements or limitations on redemptions, such as approval of the board or shareholders. Further, contractual obligations in the business’s operating agreements (such as a shareholder agreement) may also impose restrictions or requirements for such redemptions.
If the company has gone public, the redemption of common or preferred stock may implicate even more stringent federal securities regulations, including concerns relating to issuers’ compliance with the ’33 Act, the ’34 Act’s Rule 10b-5, Rule 13e-4 Tender Offer Rule, Subpart F-Part XIII-Sec. 901.—Acquisition and Disposition of Foreign Corrupt Practices Act of 1977, the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder, the Dodd-Frank Act, and SEC stockholder disclosure rules.
Redemption Agreements vs. Buy-Sell Agreements
There are significant differences between redemption agreements and buy-sell agreements. However, there are similarities as well, in that each type of agreement is designed to decide in advance what happens when an owner dies or sells her interest, and under what conditions the remaining owners of a business purchase the ownership interest.
A redemption agreement provides that upon death or other triggering events, the deceased owner’s interest will be purchased by the business, whereas a buy-sell agreement allows for the sale of an ownership interest to someone other than the business itself.
Buy-sell agreements are preferred in situations where someone outside the company might want to buy into the ownership and where the business may not be in a position to purchase the ownership interest. In going public transactions, for example, the employee may exercise options to buy stock issued under an existing incentive stock plan , or to buy new stock in an initial offering of the company’s stock. In these transactions, the buyer is an outsider who uses the company’s registration statement in connection with the purchase. Thus, a buy-sell agreement is preferred.
Redemption agreements are useful where the business can afford to buy the interest from the owner, or where the purchase will be financed by insurance on the owner’s life so that the business can use the proceeds of the policy to buy the owner’s interest. In this kind of transaction, the buyer is the business itself.
In situations where family LLCs or partnerships are involved, the family members may not want to consent to or pay the purchase price to an outsider as a third party buyer pursuant to a buy-sell agreement. Instead, the family may prefer to have the business purchased by those family members who continue with the business, as opposed to selling it on the open market.
Common Pitfalls and How to Avoid Them
One common mistake often made in the drafting and execution of redemption agreements is the failure to obtain the requisite releases from the spouses of ownership interests. Frequently, a spouse of a shareholder or partner will be a "silent" or "sleeping" partner who has never taken part in the business. However, upon separation or divorce, that person will suddenly assert a legal interest in the business, and will be entitled to share in the proceeds of the sale or redemption of the interest(s) if they are not properly excluded under a redemption agreement. Often, owners will simply leave them off the list of signatories, or forget to include that person’s spouse, thereby invalidating the redemption with respect to that interest.
Spousal consent should always be obtained as a part of any separation or divorce and should invariably include a waiver of rights to the business. In business law, especially in closely-held corporations, it is a common practice to require the signature of the spouse on personal guarantees, buy-sell agreements, partnership agreements, and other business documents to ensure that the spouse waives all rights to the business interest. If a redemption agreement is executed without spousal waiver and a subsequent action is brought by the spouse of the foregoing owner, then the entire agreement may be set aside as to the interest(s) that were at issue.
Another potential pitfall is the failure to consider the tax structure of the corporation. For example, there are "S" corporations which are taxed differently than their taxable counterparts, and there are groups of corporations referred to as "affiliated corporations" for tax purposes. In an S-corporation, the income of the corporation is taxed to the shareholders as though it was passed through to them. If shares in an S-corporation are transferred or redeemed, or if the company is liquidated, or some other event occurs which requires a new valuation for tax purposes, the IRS will apply special rules and may not accept the price established in a separation agreement. If an affiliated group of corporations is included in the redemption, each corporation should be looked at separately. The rules for determining whether corporations are affiliated, and their tax liability, are often different than the rules used for corporate control or continuity of business.
Real-World Examples of Redemption Agreements
Real world examples of redemption agreements, although scarce in comparison to the more well-known separations agreements, exist across various industries. For example:
In a case decided in 2016, an employee working in financial services entered into a redemption agreement whereby shares he received as part of his compensation would only be vested if he remained with the employer for a specified period. On the other hand, if the employee was terminated for cause before the expiry of the vesting period, the shares would not be vested, and the employee would lose his right to them. Smith v. National Money Mart Company et al. illustrates how redemption and vesting agreements can be used by companies to ensure employees remain with the company and reward them for their service. The court in Smith, noted that: "The Defendants were entitled to impose articles to discretion involving the rights to shares that were designed to vest after a specified term, subject only to earlier vesting in certain circumstances including wrongful dismissal without cause and retirement (but not for cause termination or resignation)". There, the court upheld the redemption agreement as reasonable.
On the other hand, in a case where the court found an option agreement between the parties was unenforceable, a redemption agreement may not be appropriate. In this case, the plaintiff had signed an option agreement one day before his termination, which provided for financial compensation of up to $2,289,063.78 plus interest. Further, a letter from the defendant to the plaintiff set out the option price and profit sharing arrangement. The plaintiff alleged that the second document was invalid and that it did not reflect the true agreement between the parties. The defendant contended that the option agreement and the letter "should be read together to form the complete contract" between the parties. On this basis, the defendant argued that the contract was subjective and should be enforced. However, the court in Martin-Damato (c.o.b. MetaTrader, Mobile Forex Trading Company Inc.) v. Bodnarczuk et al., found that there was no enforceable option agreement because: "(a) there was a material change to the contract (the substitution of a bonus and profit sharing formula for a simple payment of money) that was not agreed to by both parties; and (b) the option agreement included a right of indemnification that was inconsistent with the parties’ agreement."
In 2021, a redemption agreement was relied on by an employer in the hospitality industry to ensure that a former employee was held to his obligations. In order to avoid having to repay his outstanding shareholder loans upon his departure, the plaintiff had entered into a redemption agreement whereby the plaintiff sold back all of the shares he held to the defendant (the employer). The redemption agreement further required the plaintiff to repay his outstanding shareholder loans within six months at an 18% annual interest rate. When the plaintiff did not comply with the redemption agreement by repaying the shareholder loans by the deadline provided, his former employer commenced a legal proceeding to enforce the redemption agreement. Because the court found that the redemption agreement was unambiguous, and there were no language issues, the court declined to consider a possible reductio ad absurdum where a former employee could resign, enter into a redemption agreement and then defeat the redemption agreement by arguing it was not enforceable. The court held that the plaintiff was required to pay the amounts owing pursuant to the redemption agreement because the agreement was enforceable and there was no basis to excuse him from his obligations.
Conclusion: The Importance of Professional Guidance
In conclusion, it is clear that redemption agreements can be complex and have varying provisions depending on corporate bylaws, shareholder agreements or other contracts pertinent to the company. When entering into a redemption agreement, it is important to understand the key components of how the redemption will be funded, and the impact of such on the redemption price and tax implications for the corporation and the redeeming shareholder. Beyond the complex drafting of the agreement, the tax implications need to be considered at the outset and throughout the leading up to and following the sale of shares. Not only do the redeeming shareholders need to consider the income tax implications on the sale of shares from a tax perspective, but also from a financing perspective, as these transactions are often financed internally. Further, as was discussed, if a redeeming shareholder is provided with a loan from the corporation to assist or finance their purchase of shares , subtle provisions within the redemption agreement can result in tax consequences for the corporation or the redeeming shareholders.
Every situation is different and requires a great deal of attention to detail and consideration of corporate bylaws and other agreements concerning the corporation and the shareholders in order to determine the best way to complete a redemption of shares. Proper planning will ensure the redemption can be satisfied while having the least amount of impact on the corporation and the redeeming shareholders. Further, tax implications must also be considered at every step of the process.
This article is meant only for a general overview of some of the key components of a redemption agreement. Given that every corporate situation is unique, obtaining proper advice in entering into a redemption agreement is critical to minimizing the tax impact on the corporation and minimizing the tax impact of any funds received by the redeeming shareholder.