Buy-Sell Agreements
20-plus issues for every closely held business owner to consider
Key Takeaways:
Buy-sell agreements come in three basic forms but must be individually tailored to suit the specific needs of your business.
Make sure the agreement meets your ongoing needs, including tax, retirement, insurance and funding issues.
Without appropriate “exit” plans in place, ownership changes can be worse than Hollywood divorces—bitter, expensive and devastating to all involved.
Almost all owners of closely held businesses put all of their time, effort and money into launching and growing their businesses. Tragically, they put little effort into protecting what they have built from devastation caused by one or more of the owners leaving the business. Without an appropriate “exit” plan in place, changes in business ownership can be worse than a Hollywood divorce—bitter, expensive and devastating to all involved.
Don’t be fooled! Changes in ownership happen every day in all types of businesses for a multitude of reasons: death, retirement, disability, divorce, voluntary and involuntary termination of employment, lawsuits, financial and economic setbacks, bankruptcy, and selling and gifting interests, just to name a few. The disruptions caused by these events usually result in severe financial consequences for everyone involved, including collateral damage to customer, supplier, banking and employee relationships as well as to long-term company goodwill.
Consider a buy-sell agreement from Day One
Perhaps the biggest tragedy is that most, if not all, of the aforementioned problems can be avoided by putting a well-drafted buy-sell agreement in place right from the start. That’s when all the owners are still in the “honeymoon” stage of the business and relations are most amicable. However, it is never too late to put a buy-sell agreement in place, and some honest thought and open communication will strengthen and protect the business and bring peace of mind to everyone involved. Remember, ownership changes are bound to happen, but having a plan in place to deal with those changes will always smooth out the road ahead.
Next steps
Now that you are convinced that a buy-sell plan is critical for the health and well-being of both the business and the individual business owners, where do you go from here? First, consult with an experienced business lawyer who can walk you through the process and help craft a plan that fits the specific needs of both the business and the individual owners. Second, understand that no two agreements are ever the same, although they generally fall into one of three categories:
1. Cross-Purchase Agreements, which can be ideal for a business with a small number of owners. When a triggering event occurs, the remaining owners directly purchase the departing owner’s interests in the business.
2. Stock Redemption Agreements, which can be simpler and easier to structure. Generally they can be better-suited for entities with more owners. With these types of agreements the entity purchases the ownership interests of the departing owner. The remaining owners receive an increase in the value of their interests, not in the number of interests they own.
3. Hybrid Agreements, which are a combination of cross-purchase agreements and redemption agreements. Generally the entity has the obligation to redeem the interest of the departing owner, but the remaining owners have the option of directly purchasing the departing owner’s interests if the entity is unwilling or unable to do so.
In order to determine which type of agreement will best suit your needs, consider the following issues:
How many owners does the business have today and will have in the future?
Is the business family-owned or are third parties involved?
What type of business is involved, and are there specific issues that need to be addressed relating to the entity’s business, such as professional licensing or trade issues?
What is the legal structure of the business: corporation, S corporation, partnership, limited liability company?
What is the age and health status of each business owner?
Is each of the owners insurable?
What percentage of the business does each owner hold?
What is the value of the business, and how is that value determined?
What are the tax implications of each type of agreement?
What are the transfer implications of each type of agreement?
What restrictions will be put on the transfer of interests?
Will the interests be subject to rights of first refusal?
How will the business be valued and the purchase price determined? How often will the business be revalued? Will the interests be valued differently depending on the specific transfer event?
Will there be penalty provisions for violating the terms of the agreements and/or conduct damaging the business?
How will the transfer of interests be funded? Will insurance such as life insurance and disability insurance be mandated, and if so, how will premiums be paid?
How will the transfers be paid, all upfront or over time? If the payments are over time, what are the terms and the arrangements to secure payment?
Is the agreement aligned with other important legal documents such as the entity organizational documents, employment agreements, business agreements and contracts, banking agreements, and the estate planning documents of the individual owners?
Coordinate the agreement with related property that may be owned by each of the business owners. Examples include affiliated businesses, insurance policies, land and personal property, intellectual property, and leases.
How will termination of the business be handled?
How often will the agreement be reviewed? Doing so annually is a good idea.
How will disputes related to the agreement be handled—litigation, mediation or arbitration?
The foregoing is not a complete checklist of every issue that needs to be considered, but it will give you a good platform to begin discussions between you and your legal counsel.
Conclusion
First, properly structured buy-sell agreements are critical to the survival of any closely held business; they are not an option. Second, these agreements must be tailored to the specific needs of the business. One size doesn’t fit all. Finally, businesses and relationships constantly change; consequently, buy-sell agreements must be reviewed and updated regularly. An out-of-date agreement is next to worthless.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc. The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles. Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.