Buy-Sell Agreements: Protecting the future of your business

Issue January 2015 By Bryan C. Natale

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.