Why Every Business Should Develop a Comprehensive Buy-Sell Agreement
It can be anti-intuitive for some people, but when getting into a business, one needs to plan how to get out of the business. There can be many options and situations for a sole owner of a business. The number of possible circumstances multiplies with each owner. Having a roadmap that provides an outline to pre-agreed terms and steps will help resolve many complications, misunderstandings and disagreements in the future.
A buy-sell agreement is a basic business necessity. A buy-sell agreement is a contract between business partners. The typical elements outline whom, what and when a stock ownership transfers under triggering events.
It is easy to ignore this contingency planning, however it is not a question of if but of when. Planning for death, disability or retirement will not help the agency run any better today. However, good planning will allow the surviving family and remaining owners to work through the difficult period with a smoother transition. An agency owner that spends their life building a firm, needs to make sure that the firm does not dissolve or sell for pennies on the dollar when they are no longer active.
Every agency needs to have a death, disability and retirement buy-sell agreement, regardless of the particular business organization. Corporations, partnerships and sole proprietorships may each require a different type of buy-sell agreement.
For example, partnerships are typically dissolved upon the death of a partner and certain legal requirements apply. Sole proprietorships are in the most vulnerable position. They will need to establish a contingent buy-sell with an agent they trust, a family member or a key employee. Corporations may carry on, but the sale or retirement of the stock will need to be resolved.
Each buy-sell agreement must be tailored to meet the unique circumstances of the particular situation. It can be part of an operating agreement or a stand alone document. Competent legal and tax advice must be used to draft an effective document. The following are some common elements that buy-sell agreements should include:
- The agreement should state who could buy a departing partner’s or shareholder’s share of the business. This may include outsiders or be limited to other partners/shareholders.
- What events will trigger a buyout? The most common events that trigger a buyout are: death, disability, retirement, or an owner leaving the company. Also consider including terms in the case of a “forced” buyout of a shareholder.
- A method to determine the value of the stock.
- A specific outline of how the purchase price will be paid for. If life insurance will be used to fund the agreement, a definite provision regarding the arrangement should be included.
- A provision to allow for the altering, amending or termination of the agreement.
Establishing the Purchase Price
The establishment of the purchase price can often be the weakest link in any buy-sell agreement. Stating a specific price is very dangerous. It must be updated annually and based on reasonable assumptions. Using a formula (i.e., multiple of revenue) is safer however it may also eventually become outdated. Formulas also can be inaccurate under unusual circumstances.
The best method to determine the purchase price is to require a professional appraisal at the appropriate time. This allows an unbiased professional to take all current circumstances into consideration. A current appraisal from an outside party can also help limit disagreement on the value.
Terms of the Payout
The terms of the payout needs to be clearly stated. The purchase price can be paid in a lump sum or it can be structured with some type of installment. The manner of payout should be designed to meet the needs of the seller, the financial needs of the business, while minimizing taxes. Allow flexibility to take into consideration the changing amount of capital that is available to pay the purchase price.
If the payout period is reasonable, installment payments can be made from the normal cash flow of the operation. A lump sum arrangement needs to be planned in advance. It can be paid from retained earnings, a loan from a bank or insurance company or covered by a life insurance policy.
When the prospective seller is insurable, a business life insurance policy is an attractive approach to obtain the funds needed to affect the transfer. Operational details and the tax consequences of life insurance will vary based on the type of agreement.
For example, in a cross purchase plan, each owner carries enough insurance on each of the other principals to buy their share of the deceased member’s interest. In some cases the firm can buy a cash value type of policy that also can be used to fund the retirement of an owner, as well as paid upon their death.
Disability of an Owner
Often, when a co-owner becomes disabled, problems for the other owners of an agency are greater than if that owner dies. Unfortunately, most agencies do not have enough insurance. It is often inadequate. The prospect of having to deal with a disabled partner is not palatable and is best addressed when all parties are fully cognizant of the terms of the agreement and not under duress.
Disability is often termed “a living death.” As in the case of death, a disabled owner creates the issue of retaining business and often management of the firm. The difference between these two scenarios is that the disabled person will still have the need for income.
If the owner attempts to continue as an active owner despite the fact that they may have no economic value to the firm, the other owners will experience frustration. Preplanning for this event will minimize the emotional aspects of the situation since all parties have already determined a fair solution.
The disability clause in a buy-sell agreement must be carefully crafted. The determination of what constitutes a disability must be clear and inclusive. Utilizing standard definitions such as from a health insurance policy or from Social Security may resolve the perplexity of the problem.
Another critical issue is whether the buyout for a disability should be mandatory or optional. A total and permanent disability may be treated the same as a death with the remaining shareholders obligated to purchase the disabled principal’s interest. Alternatives would include an option to purchase or a first right of refusal.
The issue regarding continuing income to the disabled owner is the toughest problem, financially and morally. The solution may or may not be integrated into the disposition of ownership interest. The most common approach is to have a plan that allows the continuation of a salary for a period of time and then a buy-out at the end of that period. As long as all parties agree and understand these terms, this can be the most equitable of agreements.
A properly funded disability program for the agency will resolve future headaches. An income continuation plan may be self-insured by the agency or it may be insured with a disability insurance policy. The most desirable plan will allow for the continuation of income to age 65.
When adequate income protection has been arranged, the disposition of ownership becomes less pressing. The disabled principal will not become a financial burden to the firm and the owner will not be forced to immediately sell their interest in order to obtain income.
All agreements must take into consideration any tax consequences. Thorough estate planning must be part of the process. Determination of the deductibility of insurance premiums or any other funding techniques must be established and included in the analysis of the plan. If premiums are deducted, benefits are not tax free to the recipient. Tax considerations will vary whether the situation is a death or disability. Since tax treatment will vary, proper consul is highly recommended.
Every business needs to have an arrangement for the death, disability or retirement of the owners. The damage that occurs when a firm does not plan for these events can be devastating not only to the agency but also to the family members. The business may end up being sold at a bargain, may need to get drastically scaled back or even totally collapsed. Proper planning will limit most problems and allow for the successful perpetuation of the agency.