The Essential Business Agreement: Part I
By Maurie Cashman
The business continuity agreement can be one of the most important documents that a co-owner of a closely held business will sign. Last week we discussed the Stay Agreement, an important incentive in holding key employees in place during an ownership transition. This week weâ€™ll talk about the Business Continuity Agreement, the key to transitioning a business according to the ownerâ€™s wishes on a predetermined basis. The following Anvil In-Law hypothetical case study illustrates the importance of a well-designed business continuity or buy-sell agreement.
Dick Anvil liked his son-in-law, Joe Mower, and appreciated what he had done for his business. Joe had been with the company for 15 years, had gradually assumed operational management and was the acting CEO. He had purchased 25 percent of the ownership from Dick over the yearsâ€”mostly at a low value in recognition of his services. Eventually, everyone knew that Joe would own the company. But that was before Dick died and Joe’s sister-in-law became the executor of the estate. She was happy to sell the balance of the company to Joe â€” but at full fair market value and in cashâ€”or she would sell the business to the highest bidder. Only later would she realize that without Joe’s cooperation, the business was unlikely to sell. No buyer would want a disgruntled minority co-owner, particularly the current CEO. Both owners had issues that could have been discussed and resolved before a transfer event such as a death or a sale opportunity arose. These involved business value, governance, control and business strategy. Had Joe and Dick created a business continuity agreement, the business would have transferred at a fair price to the benefit of all concerned. Now, it likely wouldn’t continue at all.
The business continuity agreement, or buy-sell agreement, controls the transfer of ownership in a business when certain events occur. These events usually include the death of an owner or a sale and transfer of stock from one owner to another or to an outside party. You also should consider having the agreement include transfers upon an owner’s permanent and total disability, termination of employment, retirement, bankruptcy, divorce, and a business dispute among the owners. These are commonly called â€œtriggering events.â€
Upon a triggering event, the business continuity agreement may require the business or the remaining owners to purchase the departing owner’s stock; or it may give an option to the business or the remaining owners to buy that ownership interest. It may give the departing owner(s) the option to require the company to buy their ownership interest.
The agreement also should establish the value of the stock, set the terms and conditions of the buyout, and give additional protection to all owners. The business continuity agreement tells you to whom you can sell, at what price and terms, and under what restrictions you can sell your stock.
Advantages of a Buy-Sell Agreement
With buy-sell agreements, disadvantages are difficult to find if the document is well-drafted and kept updated for changes in ownership, value and other circumstances. Here are the features that owners will often incorporate into buy-sell agreements.
Controlling Transfer of Ownership. Ownership in the business can be transferred only in accordance with the agreement. This benefits both the owner desiring to transfer stock and the other owner or owners wanting to acquire stock. In the first instance, the buy-sell agreement can assure a selling shareholder, or his/her estate, of a purchaser for fair value and upon terms and conditions that are mutually acceptable. For the remaining owners (such as Joe), the agreement means that any transfers of ownership must be made, or at least offered, to them. This eliminates the threat that an outside party or a co-owner’s heirs will become owners of the business, thereby reducing management, control and value.
Valuation. Valuation is set not only for purposes of a sale, but also for estate tax valuation purposes. Privately owned businesses are very difficult to value. Your idea of your business’s value at your death may be much lower than the IRS’s. If you haven’t created a binding process for valuing the business, the IRS is free to impose its own value determination. Design a valuation appraisal process in your buy-sell agreement to avoid problems like this.
Terms and Conditions. The terms and conditions of any transfer of stock, including interest rate, length of buyout period and security, can be established. In addition, where possible, the transfer can be funded. The agreement provides clarity to a departing shareholder of how much money they will receive and how often. The remaining shareholders also know the extent and duration of their buyout obligations. This allows both parties to plan their respective futures.
Had Joe and Dick created an agreement providing for these, a valuable business would have been transferred to the benefit of all owners, as well as the employees, customers and stakeholders wishing to see Anvil continue.
As we have discussed, there can be many advantages to a buy-sell agreement in regard to establishing transfer of ownership, valuation and terms and conditions.
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