While a buy-sell agreement is critical to any closely held business, simply having an agreement doesn’t guarantee it will be effective. Ensure your legacy and the future of your business is protected.
WHAT IS A BUY-SELL AGREEMENT?
A buy-sell is a legally binding agreement that governs the reassignment of an ownership interest in the event of an owner’s death, disability or withdrawal from a business. It helps take the distribution of assets out of the hands of a court and helps to navigate the various legal and tax implications of a business owner’s voluntary or involuntary withdrawal.
There are two primary types of buy-sell agreements:
- Cross-Purchase – Surviving owner(s) agree to purchase the departing owner’s interest in the company
- Entity-Purchase (Redemption) – The business entity agrees to purchase the departing owner’s interest in the company
WHY HAVE A BUY-SELL AGREEMENT?
The departure of a business partner is accompanied by a variety of emotions and decisions, particularly if their exit is due to a sudden or unexpected event.
Stressful times are often best handled with a plan. A buy-sell agreement can take emotion out of the situation and serve as a roadmap moving forward. A buy-sell also provides the opportunity to define a formula for the value at which the ownership interest will transfer, removing what can otherwise be a very contentious negotiation. Finally, it allows for proactive estate planning to avoid major tax consequences.
TERMS & PROVISIONS TO CONSIDER
It’s important to outline the terms of a transfer with specificity. Leave as little room for interpretation as possible. Be sure to consider these critical provisions.
- Payment Terms – Will there be a cash purchase or is financing permitted? Will the surviving estate or family members finance any of the debt? If so, what are acceptable terms and a reasonable interest rate?
- Timing – How long after the triggering event must the payment be made? Is there an expiration date?
- Right of First Refusal (ROFR) – Will an owner be permitted to sell his or her interest to a third party provided no existing owners refuse or waive their first right to purchase the interest?
- Defined Level of Disability –What level of disability warrants the replacing the disabled owner?
VALUATION METHODS
One of the major benefits of a buy-sell is to proactively define at what value an owner’s shares or interest will transfer. Valuation is a complex subject. For a buy-sell to be effective a valuation formula or method needs to be outlined. There are three main methods for defining value for a buy-sell agreement:
- Arbitrary Agreed-upon Value – This method is often used when an agreement is drafted early in the formation of the company or as a proxy until a more comprehensive approach can be taken. The owners of the company will determine a fixed mutually agreed-upon value, such as $5 million and specify this value in the agreement. The downside of this method is that the value will likely change over time and if the agreement hasn’t been updated, one party will walk away unsatisfied.
- Formula – Any number of formulas can be chosen to determine value. Some companies specify a multiple of earnings or a multiple of revenue based on an agreed upon period. For example, the agreement may specify that upon the owner’s departure, value will be determined to be four times trailing twelve-month (TTM) earnings. Like the agreed-upon value method, the formula should be revisited and updated as appropriate as time passes. What may have been a reasonable approach on day one may no longer be realistic five or ten years later.
- Fair Market Valuation at time of the transfer – This method postpones the valuation until a triggering event occurs. Often an unrelated third-party is brought in at this point to provide a formal, perhaps certified, opinion of value. The outcome of that professional valuation is deemed to be the basis for the transfer of the owner’s shares or interest.
COMMON MISTAKES WHEN DRAFTING A BUY-SELL
A buy-sell agreement isn’t a high-level document. The longer and more complicated the agreement is, the more opportunity there is to make a mistake.
Avoid these common errors when drafting a buy-sell.
- Not creating a buy-sell early on in the formation of your company.
- Attempting to draft the agreement yourself. A buy-sell is so important to your family, business partners and the future of your company that we recommend you always enlist the help of a professional.
- Not involving your full team of advisors when creating or updating the agreement. A buy-sell may be a legal document, but it has a far greater reach. Its creation should be collaborative. In addition to hiring an attorney to draft the document, make sure to involve a CPA to review tax implications, a wealth advisor to review financial terms and a valuation or exit advisor to benchmark valuation methods and exit options.
- Not having a valuation clause or detailed formula for determining business value.
- Not revisiting and updating the agreement on a regular and frequent basis. Your key documents should always be updated to reflect the dynamic nature of business.
- No consideration for non-death events (disability, divorce, disagreement or distress).
- Ambiguity. Details need to be specifically outlined throughout the agreement and reviewed by the entire team of advisors. General terms open the door for conflict and misinterpretation.
HOW TO FUND A BUY-SELL AGREEMENT
Drafting the agreement is a critical first step, but it’s equally important to ensure that the agreement is funded. A well-drafted buy-sell is still a major challenge if the surviving owners don’t have the means necessary to purchase the former owner’s interest in the company.
The most common method for funding a buy-sell is through the purchase of life and/or disability insurance policies.
In a cross-purchase agreement, each owner will take out a policy on the other owners in an amount sufficient to purchase the remaining interest.
In an entity-redemption agreement the business will own a policy on each owner.
The benefit amount of the insurance policies should be based on a reasonable estimation of value that is in alignment with the method specified in the agreement.
It’s important that the estimated value is revisited regularly to ensure that the agreement is fully funded at all times. A common mistake is to draft the agreement early on, but not reconsider the value of the business as it grows over time. Leaving an old life insurance policy in place that is insufficient when the time comes to act can have devastating consequences.
WHAT’S NEXT
A buy-sell is just one of the key documents you should have as a business owner and just one part of an overall exit plan. If you want to learn what other actions you can take today to position yourself for an eventual exit on your terms another good place to start is our article
3 Steps to Get Started on an Exit Plan
If you could use hands-on help or guidance, feel free to