What Is a Stock Redemption Agreement and Why Might I Need One?

In a public corporation, shareholders can sell company stock at the current market price at any time. However, selling shares in a privately held corporation is more complicated because stock cannot be sold to the general public.

Typically, private companies have shareholder agreements that only allow stock to be sold in certain situations. The terms of the sale are dictated by a type of buy-sell contract known as a stock redemption agreement. Stock redemption agreements should be established at a company’s founding to ensure business continuity and an orderly transfer of ownership during a planned—or unplanned—event.

Ownership Interests in Private and Public Companies

When a company “goes public,” it offers shares for sale as part of an initial public offering (IPO). IPOs allow a company to raise capital and boost its public profile. At the same time, the founders of a company going public lose some control over the business entity as ownership interests are watered down by additional shareholders.

Often, companies remain privately held and do not issue stock to outside parties. According to the Small Business Administration, of the approximately 32 million small businesses in the United States, many are privately held.^[1]

In small business partnerships, owners may be actively involved in business operations or simply passive investors. Regardless, small, privately owned businesses are much more selective than public companies in choosing who can hold ownership shares.

Small businesses are tight-knit, so maintaining strong internal dynamics is key to successful operations. If a company fails to control the transfer of its ownership interests, an owner leaving could upend the business.

Buy-Sell Agreements and Stock Redemption Agreements

Small businesses use buy-sell agreements to avoid internal conflict and disruption when an owner exits the company. An owner’s departure could be voluntary (e.g., to retire) or involuntary (e.g., the owner passes away or is asked by other owners to leave the business). Owners may want to sell their business shares to a third party, or another owner might want to buy them out.

An owner’s voluntary or involuntary departure is commonly known as a triggering event for the sale of the owner’s share of the business pursuant to the buy-sell agreement. The buy-sell agreement is a contract that requires the departing owner’s shares to be sold to the company or to the remaining owners. Specific terms of the sale are stipulated in the buy-sell agreement, and often include call rights, put rights, deadlock provisions, and a right of first refusal.^[2] While the exact provisions may vary depending upon the needs of the business and its owners, the purpose of a buy-sell agreement is to provide for an orderly buyout process when a triggering event occurs.

A stock redemption agreement is a buy-sell agreement between a private corporation and its shareholders. The agreement stipulates that the company must purchase its stock back from the shareholder upon the occurrence of a triggering event. The company uses its own funds (not the funds of the other shareholders) to satisfy its purchase obligation outlined in the stock redemption agreement. The reacquired shares have the status of treasury stock, which can be retained, reissued, or canceled.^[3]

In some cases, stock redemption agreements permit the company to purchase life insurance or disability insurance policies for shareholders that is used to purchase their shares if they die unexpectedly or become disabled. The company pays the policy premium and is the beneficiary of the insurance policy. This is called an insured stock redemption agreement.

Should My Company Have a Stock Redemption Agreement?

Without a stock redemption agreement, sudden shareholder exits can bring about chaos. For example, a shareholder in a closely held corporation could die and pass on company shares to a family member, resulting in someone with potentially no business experience becoming a major shareholder with an important voice in the election of officers and directors. Such an event could place other shareholders in a difficult position—just as difficult as if the estate of a deceased owner sold their company interests to an outsider.

Buy-sell agreements, including stock redemption agreements, not only help to restrict the ownership of the business, but also stave off conflicts over the terms of a buyout, including price. Most buy-sell agreements contain a valuation clause that specifies a method for valuing the business and what its shares are worth.

More generally, buy-sell agreements provide a plan for addressing the departure of an owner. The absence of a solid, legally binding agreement to address owner departures could lead to conflict, litigation, and even the dissolution of the company.

Stock redemption agreements may be advisable for a business with several shareholders. As an alternative to a cross-purchase agreement between company stockholders, it could be simpler to include the company as a party under a stock redemption agreement, especially in the case of an insured stock redemption agreement.

Consult an experienced business attorney to determine whether a stock redemption agreement, cross-purchase agreement, or hybrid agreement with elements of both is right for your company. Buy-sell agreements must contain clear language since ambiguity will undermine the intent of the agreement. Essential provisions to be addressed in the agreement include valuation, terms of repurchase, payment, and voting rights. In addition, an attorney or tax professional can advise you on any tax issues that may arise under a stock redemption.

The best time to implement a buy-sell agreement is at the formation of the company, though they can be executed at any time. Agreements should be regularly reviewed to ensure they reflect any changes to the business structure and its value. Call Littleton Legal today at (918) 608-1836 to help with your buy-sell agreements.

[1] Frequently Asked Questions, U.S. Small Bus. Admin. Office of Advocacy (Oct. 2020), https://cdn.advocacy.sba.gov/wp-content/uploads/2020/11/05122043/Small-Business-FAQ-2020.pdf.

[2] Hugh H. Lambert, CPA/ABV and Briana K. Wright, Considerations for Using Buy-Sell Agreements: The Advantages for Owners, Accountants, and Financial Advisors, The CPA Journal (Oct. 2018), https://www.cpajournal.com/2018/10/03/considerations-for-using-buy-sell-agreements/.

[3] Daniel Kurt, What Is Treasury Stock? Definition, How They’re Used, and Example, Investopedia (Apr. 16, 2021),

https://www.investopedia.com/ask/answers/what-is-treasury-stock/.