Buy-Sell Agreements 101
Many possible risks can threaten the continuation of a business after the business owner’s death, including loss of direction or mission, loss of leadership with business experience and competence, disputes over proper management, disputed probate proceedings, and lack of communication.
A buy-sell agreement is a specific type of agreement among business owners that pertains to the transfer (or limitation on transfer) of ownership interests.
The buy-sell agreement provides the right (or obligation) to transfer ownership interests upon the happening of numerous possible triggering events, and creates a funding mechanism for such transfers. Triggering Events include:
1. Death of an owner – reduces uncertainty of how death of an owner will affect the entity and may lay out a succession plan.
2. Termination of owner’s marriage by divorce or death. May prevent transfer of business interest to spouse in divorce.
3. Attempted transfers outside of intended shareholders (includes gifts and sales by other owners)
4. Estrangement clause – can provide an exit strategy if the owners cannot resolve differences of opinion.
5. Incapacity or disability of owners *
6. Insolvency of company and owners *
7. Retirement of an owner *
8. Cessation of owner’s employment *
* Important when the owners are expected to contribute to the management and operation of the business.
By choosing the appropriate triggering events, a buy-sell agreement can be used to address the following issues confronted by a closely-held business:
• Providing for a surviving spouse,
• Buy-out of family members not working in the business, and
• The difficulties of management by more than one child of the current owner.
RESTRICTING PERMISSIBLE TRANSFEREES
The most common provision in a buy-sell agreement creates a restriction on the ability of an owner to transfer any part of her business interest to a new owner. An example of an outright restriction would be the prevention of a transfer of stock in an S corporation to a person or entity which would cause the corporation to lose its S corporation status. More commonly, family-owned businesses desire to restrict ownership of the company to direct family members. It is important to note that restricting permissible transferees may impact the value of the business interest because the pool of potential buyers is smaller than it would have been without such restrictions.
TYPES OF PURCHASES UNDER BUY/SELL AGREEMENTS
1. Redemption (business purchase) agreement: the business itself purchases the stock of the selling owner upon the occurrence of a triggering event.
2. Cross-purchase agreement: the selling owner is required to sell his or her shares to each of the other owners, or to those remaining owners who elect to exercise an option to purchase, upon the occurrence of a triggering event.
3. Hybrid cross-purchase agreement: is a combination of a corporate redemption and owner cross-purchase agreement.
VALUATION METHODS FOR DETERMINING PURCHASE PRICE
1. Set a fixed purchase price on a periodic basis. Although simple, this can give rise to problems if an unusual event occurs rendering the fixed price inequitable or if the owners simply fail to agree on a price for a particular period.
2. Use book value. This method provides a mechanism whereby price can be determined with relatively little effort. There is a risk that it may result in a low price because the book value method generally takes assets at their original cost less depreciation. Certain adjustments can be made to the book value to arrive at a more reasonable value for certain assets like marketable securities, depreciating assets, or inventory.
3. Set the value by formula. Formulas may be based on some multiple of earnings, discounted cash flow, or other financial data.
4. Use the appraised value. This is often seen as the most fair method by persons with differing interests. This approach may be more expensive and time-consuming, although relatively low-cost valuation options exist.
OTHER BUY-SELL PROVISIONS TO CONSIDER
1. Periodic review: it is advisable for owners to include provisions in a buy-sell agreement requiring the shareholders revisit and approve the terms of the agreement periodically or following specified events to ensure that the agreement continues to serve the best interests of the business and its shareholders.
2. Voting provision: buy-sell agreements may include provisions requiring the owners to vote their ownership interests in a particular way.
3. Push/pull provisions: a buy-sell agreement may contain provisions pursuant to which any owner can set a price for his or her ownership interests and require the other owners within a prescribed period to either purchase his or her interests at that price or allow the first party
to purchase all of their shares at the same price. This approach is typically adopted when a business only has two owners.
4. Sale of business (Drag along /Tag along rights): buy-sell agreements may include provisions providing that in the event the holders of a majority of the ownership interests in the business desire to sell their ownership interest to a third party, the remaining owners will be required (or have the right) to join in that transaction. Alternatively, this requires that if the majority owners desire to sell to a third party, the minority ownership interest will have to be also be sold for the same price and terms as the majority interests.
Proper business succession planning with use of a carefully crafted buy-sell agreement and estate planning documents will maximize a business owner’s tax benefits and achieve peace of mind in knowing that his or her business will continue to run even after he or she has relinquished control of the business.