By Maurie Cashman
If you share ownership of your company with another person, you likely have a buy-sell agreement. If you donâ€™t, getting one should be a top priority. Generally, ownerâ€™s draft those agreements because they want to control the transfer of ownership should one of them die or become disabled. Most agreements are set up so that life insurance will fund the purchase of the deceased/disabled ownerâ€™s interest if one of these events occurs.
Most buy-sell agreements also contain provisions governing lifetime (divorce, bankruptcy or retirement of a shareholder) transfers of ownership, often in the form of a first right of refusal, at a pre-determined price or agreed-upon pricing formula, in the event one owner wishes to transfer ownership to someone else.
Few owners (or their advisors) give much thought or analysis to the likelihood of a lifetime transfer. Instead they focus all of their attention on dealing with the least likely event, which is an ownerâ€™s death. But lifetime transfers occur much more often, and when they do can cause significant issues.
For that reason, owners create buy-sell agreements that may work well in the event of a shareholderâ€™s death, but forget that the same provisions will control in the case of a lifetime transfer. Because these agreements are designed for one event and used for another the result is at best, a trigger for re-negotiation, and at worst, a disaster.
Letâ€™s look at how two ownersâ€™ sole focus on death, crippled them when the thing the least expected happened.
Phil and Susan had talked about pooling their resources (Philâ€™s thriving computer services and Susanâ€™s reputation as one of the areaâ€™s best communication system designers) for years when Susanâ€™s twin brother had a heart attack at age 55. Susan realized that life was too short to keep talking about creating a partnership and the two decided to merge their talents at last.
Along with all of the other documents that Susan and Philâ€™s attorney insisted on was a buy-sell agreement that established the price and the terms of the sale or purchase. Embedded in its creation was the assumption that one of them (probably Susan since she was eight years older than Phil) would die and Phil would purchase Susanâ€™s ownership using life insurance proceeds.
Susan answered the wake up call to improve her life and lifestyle. She not only created a successful company, she replaced her daily drive across town to grab a chicken-fried steak or cheeseburger with brisk walks to the new salad shop. She joined her husband for long bike rides on weekends. She had never felt better.
Now for the kicker: Phil began to think about retiring and selling out. A look at the buy-sell agreement told him that he had to sell his stock to Susan based upon the price they had established when they assumed that there would be adequate funding because of the existence of a life insurance policy.
Phil and Susanâ€™s problems were just beginning. Because the price established in their buy-sell agreement had nothing to do with the fair market value of the company when one of them wanted to sell, the price the buyer would pay was likely to be substantially higher or lower than the companyâ€™s current value. This means that one or the other partner would suffer.
Some owners agree to ignore their buy-sell agreement and to hire a Business Appraiser to establish a fair market value for the company. Phil suggested this route, but Susan insisted that they abide by their original agreement. First, the value in the buy-sell agreement was significantly lower than the companyâ€™s current value. Second, Susan did not want to put a damper on the future growth of the company by using its cash flow to buy Phil out.
Phil felt he had proposed a fair alternative, resented Susanâ€™s intransigence and didnâ€™t want to sell his ownership interest for what he believed was an artificially low price. The two partners stopped speaking.
Philâ€™s issue with the price was just the first hurdle. Because Phil and Susan had presumed that only death would separate them, they had done no planning to minimize the tax consequences of a lifetime sale. Further, since they assumed the survivor would use life insurance proceeds (rather than company cash flow) to fund the buy-out of the deceased shareholderâ€™s interest, they had established a very short timeframe to pay for the purchase. Finally, their buy-sell included no â€œforced buyout provisionâ€ to resolve irreconcilable differences between the owners.
The only way for Phil to leave the company with the amount of cash he felt he was owed was to die. And if he died, Susan was still going to have to deal with his heirs, whom would assume Philâ€™s position and would have even less reason to work out anything other than a purchase at fair market value with Susan. He was left owning a company whose performance he had absolutely no reason to improve. She was left with a problem that was never going to go away.
The best way to prevent this deadlock within your company is to address potential problems caused by a buy-sell agreement drafted years ago for a transfer event (death) that is not the event (lifetime transfer) most likely to occur. If you suspect that your agreement may be inadequate, review it today, before one owner decides it is time to go spend time with the grandkids.