Buy-Sell Agreements Protect Co-Owners and Their Families
According to a survey of beneficiaries of business owners*, only 21 percent had a formal plan to transfer their share of the business at their death or disability. Of the business owners who did have a plan, many have not updated their plan in years.
Every business with co-owners should address the need for a Buy-Sell agreement the moment the business is formed or as soon after that as possible. Why?
In the event of the death of an Owner, a Buy-Sell can protect both the family of the deceased Owner and the surviving Owners. Funded by insurance, the surviving Owners can buy the interests of the deceased Owner and protect themselves from dealing with family members of the deceased Owner, and vice-versa. It also provides liquidity to the family of the deceased Owner.
A divorcing spouse or creditors of an Owner can attack the interest of that Owner, a Buy-Sell can protect the other Owners from dealing with unwelcome third-parties who may not have the best interests of the business in mind.
In the event that an Owner wants to sell his interest, a Buy-Sell can give the non-selling Owners, or the entity itself, a right to purchase the selling Owner’s interests, and protect them from interference by a third party.
A Buy-Sell can protect all of the Owners from one of the Owners using their business interest as collateral, and losing that interest to the lender, resulting in institutional intrusion that may want nothing more than a speedy liquidation of the business to recover as much as possible on its debt.
A Buy-Sell can provide a framework for what is to happen in the event that an Owner is disabled or becomes incompetent, or just wants to retire from the business.
Knowing that there is a plan in place for Business Succession can provide comfort to Lenders, suppliers and employees.
And finally, we recommend Buy-Sell agreements because they raise or address important collateral issues:
Unlike public companies, interests in closely held businesses are not readily
It is very difficult for the estate of a deceased or disabled Owner to receive a fair
value after the Owner is either deceased or disabled. The bargaining positions are simply unequal. A Buy-Sell can level the playing field.
The surviving or non disabled Owners usually do not want third party
“outsiders” as new Owners.
The surviving or non-disabled Owners may want (if applicable) to preserve S Corporation
Once the Owners decide that a Buy-Sell is the appropriate vehicle for them, a series of other issues arise. Among them is how to value the business interests, and how to provide funds for the eventual buy-out.
Agreed Value Method: The Owners agree on a value for the shares and periodically re-evaluate the price, i.e. at the annual Owners meeting. It is easy to draft, understand, inexpensive to implement and apply, and it permits all factors to be weighed by the business owners themselves. If this method is used, there should be a backup formula, if the parties fail to make the required reevaluation. This method usually satisfies the surviving spouse of the deceased Owner because the surviving spouse knows that the deceased spouse approved of the formula. As a practical matter, however, we have rarely seen Owners actually meet to re-value the business, or be able to agree on the value if they do meet. Further, unless unrelated parties own more than 50% of the business, this method will probably not withstand IRS scrutiny.
Book Value: If the book value is used to value the shares, the formula used to determine the book value should be stated in the agreement. Book value may not show the fair market value of some assets. Cash, accounts receivable and often inventories may be accepted at their book value. Assets such as machinery and equipment, patents, and real estate, unless purchased recently, will usually have values different than their book value. i.e. in an inflationary economy, real estate is often worth substantially more than its book value. The book value does not take into account future growth potential, the value of personnel and labor relations. Book value is often adjusted to include goodwill, litigation and claims.
Multiple of Earnings: The purchase price could be set at a multiple of earnings over a period of time. The accounting method used to determine earnings will effect earnings and therefore the value. An appropriate multiplier must be found. Salary adjustments and personal expense adjustments often have to be made because the Owner-employees often are paid based upon personal needs rather than bonafide employer-employee negotiations, and often relatives have been employed, benefits have been generous, etc.
Bonafide Offer: The purchase price could be set at the amount of a bonafide offer that the estate receives for the stock. This method creates uncertainty about value and such arrangements are rare. Why would anyone make a serious offer, or do the due diligence to make a serious offer, if it is only being used as a “stalking horse” for others to purchase the interests being offered for sale. It also highlights the problems with a forced sale – fair value is rarely paid when a sale is being made under duress.
Appraisal Method: An independent business appraiser determines the value. This method may be expensive and time consuming. However, in family owned businesses this may be the only viable approach. Questions become who will be the appraiser, special instructions, i.e. book value, fair market value, etc., but over time, we feel that we have developed provisions to address these concerns.
Death: Where the triggering event is death of an Owner, a method for funding the buyout should be provided for. Generally these take one of two forms – Cross Purchase Agreement or a Redemption Agreement.
With a Cross-Purchase Agreement, the Owners hold policies of life insurance on each others lives, and purchase a proportionate share of the deceased Owner’s interest. This can be cumbersome because if there are just three owners, there will be 6 separate policies.
With a Redemption Agreement (also referred to as an “Entity Purchase”), the business entity holds the policies on the lives of the Owners.
The form of the agreement – Cross-Purchase or Redemption – has very different consequences.
Call us to discuss ways today to protect your business, your family and your assets.
* (http://southwestconstruction.com/opinions/finance/0404_opinion.asp (McGraw-Hill publications)