Many business owners find success by focusing their time on
making decisions that position the business for growth and ensure
the business' competitive edge in the marketplace. Few business
owners, however, plan for contingencies that could stifle the
continuation of the business, like the death, disability,
retirement or voluntary withdrawal of a business owner. Regardless
of the way a business is organized - corporation, LLC, partnership
or sole proprietorship - if you own, in whole or in part, a
privately held business, you need to protect the future of your
business before unplanned events significantly diminish the value
of the business and risk the continuation or transition of the
business.
A buy-sell agreement is one succession planning tool that owners of
privately held businesses can utilize to plan for what will happen
when one of the business owners dies, is disabled, retires or
voluntarily withdraws. As with most business documents, a buy-sell
agreement should be considered a living document, one that is
continuously reviewed and modified in order to capture the intent
of the owners as changes occur over time with the business, its
owners and the marketplace in which the business operates.
A buy-sell agreement makes sense for any type of privately held
business entity, no matter the size, as the most basic business can
experience unexpected events and disputes among the owners. In
order to avoid confusion and create a formal process to handle
events like death, disability, retirement and voluntary withdrawal,
a carefully drafted buy-sell agreement should be a priority for
business owners whether their business is just taking off or an
already mature and operating business.
Before a buy-sell agreement is prepared for the business and its
owners, the owners must, at a minimum, consider the
following:
What type of arrangement is best? There are three
basic types of buy-sell agreements: (i) a redemption arrangement,
(ii) a cross-purchase arrangement and (iii) a hybrid arrangement. A
redemption arrangement is one in which the business agrees to
purchase the business interest from an owner (i.e., shares in a
corporation or membership interest in a limited liability company)
upon the occurrence of some triggering event (as described below).
Under this arrangement, the business controls the funding and
purchases the owner's interest. In a cross-purchase arrangement,
the owners themselves, rather than the business, agree to buy each
other's business interest. Typically, each business owner enters
into the cross-purchase arrangement and is either obligated or has
the option to purchase the business interest of his or her fellow
owner upon the occurrence of a triggering event. Under this
scenario, the individual owners must have the funds to purchase the
exiting business owner's interest. Finally, in a hybrid
arrangement, either the business or the owners have the option to
purchase the business interest of an owner upon the occurrence of a
triggering event.
What are the triggering events? A triggering event
is any event that will cause a business owner's interest to be
sold. The most common triggering events are death, disability,
retirement and voluntary withdrawal.
How will a purchase price be determined? When a
triggering event occurs and a purchase is triggered, a buy-sell
agreement should address how the purchase price is determined in
every situation. The following are a few of the common
options:
Fixed price - A buy-sell agreement may provide that the
owners initially agree on a fixed price and then periodically
adjust the price on a set schedule, as reasonably determined by the
owners (i.e., annually). While many closely held businesses use
this approach because of the benefit to set the price themselves,
there are a few drawbacks. One drawback is the owners may not have
the discipline to meet periodically as determined in the buy-sell
agreement. In addition, the owners may not agree on a fixed price
due to various motivations by each owner. Moreover, if the owners
do not adhere to the periodic schedule set forth in the buy-sell
agreement, a fixed price may not represent the current value of the
business.
Formula - A formula may be used to compute the value of
the business, which can be related to book value and/or earnings.
In theory, the formula approach should be flexible and provide an
accurate value even as the business changes over time. Ideally, the
value should be able to be calculated with only minimal input from
the business's accountant without the need for a full appraisal.
For example, the formula may be (i) the average of the net profits
(as defined in the buy-sell agreement) of the business for its last
three years, multiplied by three, or (ii) book value, or some
multiplier of that book value.
Appraisal - The business may hire an appraiser to value
the business. Ideally, the appraisal valuation should initially be
determined at the time the buy-sell agreement is first executed. In
the event that the owners do not agree on the appraisal value, the
buy-sell agreement should provide a mechanism that allows multiple
appraisals to be used in order to reach a value that all owners
reasonably accept. One drawback of the appraisal approach is that
the owners have no say in the determination of the value of the
business.
How will the purchase price be funded? In the
event a triggering event occurs, one or more of the parties to the
buy-sell agreement will need to purchase the departing owner's
interest depending on the type of arrangement determined by the
owners. As such, the ability to deliver such payment may be
difficult given certain liquidity conditions. In the event of a
death, one common option business owners use is life insurance. The
purchase of life insurance is used in both the redemption and
cross-purchase arrangement, which proceeds thereof will then be
used to purchase the deceased owner's interest. In the event of
triggering events other than death, life insurance will not be
appropriate. In this instance, it is common for the owners to agree
that the use of a promissory note for payment over a certain time
is most reasonable. In addition, the parties may agree to require a
certain percentage down payment at the time of purchase or require
an acceleration based on certain business events or performance
metrics.
What are the purchase price payment terms? The
payment terms of a buy-sell agreement can be flexible and will
largely be based on how the owners determine to fund the purchase
of an owner's interest, either by using the proceeds of an
insurance policy (i.e., life or disability), lump sum payment or
payment over time by a promissory note.
As illustrated above, there are many considerations that go into
preparing a well thought out buy-sell agreement. Accordingly, it is
critical for the owners to carefully contemplate the goals, values
and expectations of the business (and one another) before
implementing a buy-sell agreement. While this agreement can be
amended at any time by the business and its owners, it is more
prudent to get it right the first time and avoid the "do it later"
approach. The value of removing any uncertainty cannot be
overstated.