Buy-Sell Agreement. Do You Really Need One?

 

By Maurie Cashman

Do you really need a Buy-Sell Agreement? This question comes up frequently in my discussions with business owners who are in some form of partnership or corporation, and are considering an ownership transition. Last week, we discussed the problems that can arise if a Buy-Sell agreement designed for one event (usually the death of a shareholder) is called upon to manage the more likely event of a shareholder leaving during his or her lifetime. Lifetime departures may occur due to the retirement, termination, divorce, disability, disagreement between owners or bankruptcy of an owner.

“People always call it luck when you’ve acted more sensibly than they have.”
–Anne Tyler, American author

While it is true that poor design or failure to update the agreement can create significant problems, does that mean you and your co-owners shouldn’t have one in place?

NO! The business continuity agreement may be one of the most important documents that you, as a co-owner of a closely held business, will ever sign. For an idea of why, consider the case of Iowa Advertising, a fictional company.

Chris Vandeleigh’s son-in-law, George Swift, had worked for Chris for over 30 years. George had gradually assumed operational management and was the CEO. In recognition of George’s contribution, Chris had sold George—at a value discounted for minority ownership—30 percent of the company.

Everyone expected that George would one day own Iowa Advertising. But before that day arrived, Chris died and George’s sister-in-law became the executor of Chris’s estate. She decided to sell Chris’s share of the company—at its full fair market value and for cash—either to George or to the highest bidder. She did not understand at the time that no third party would acquire a majority position in a company co-owned and run by a disgruntled CEO and family member.

Had George and Chris created a business continuity agreement that reflected their wishes about value, control and successor ownership, the business would have transferred at a fair price to the benefit of all concerned. Because they had not done so, Iowa Advertising was unlikely to continue at all.

A business continuity agreement can control the transfer of ownership in a business when a variety of events occur including: an owner’s death, permanent and total disability, termination of employment, retirement, bankruptcy, divorce or a business dispute among the owners.

The Buy-Sell agreement can further 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. Lastly, it may give the departing owner the option to require the company to buy his or her ownership interest.

The agreement should establish the value of the stock or a formula to determine the value, arrange the terms and conditions of the buyout, and give additional protection to all owners. The business continuity agreement tells owners to whom they can sell, at what price and terms, and under what restrictions they can sell stock.

Advantages of a Buy-Sell Agreement

If the document is well drafted and is kept updated for changes in ownership, value and other circumstances, the major advantages of a Buy-Sell agreement are:

1. Ownership in the business can be transferred only in accordance with the agreement. This benefits both the owner wishing to transfer stock and the other owner(s) wanting to acquire stock. In the first instance, the Buy-Sell agreement can provide a selling shareholder, or his/her estate, with a purchaser for fair value and upon terms and conditions that are mutually acceptable. For remaining owners (such as George), the agreement provides 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 spouse or children will become owners of the business, thereby diminishing management, control and value.
2. Valuation is set not only for purposes of a sale, but also for estate tax valuation purposes. Privately owned businesses are notoriously 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 determination of value. Take the initiative by designing a valuation appraisal process in your Buy-Sell agreement.
3. The terms and conditions of any transfer of stock, including interest rate, length of buyout period, and security can be fixed and the transfer can be funded. The agreement provides a clear estimate to a departing shareholder of how much money he or she will receive and how often. The remaining shareholders know in advance the extent and duration of their buyout obligations. This allows both parties to plan their respective futures.

Had George and Chris created a Buy-Sell agreement with terms like these, a valuable business could have been transferred successfully. That transaction would have benefited George, Chris’s estate, Iowa Advertising’s employees, customers, vendors and community.

Next week we’ll look at more reasons for owners to consider creating Buy-Sell agreements for co-owned businesses. If you have any questions about establishing strong business continuity agreements and their role in helping you exit your business, please contact us.