If you had made some agreements at the beginning of your partnership, this would not be a time to worry. A buy-sell agreement doesn’t prevent succession or estate problems in the event one of your company’s owners encounters one of the three D’s (death, divorce or disability), but it can help guide you through the situation.
While many business owners tend to think of buy-sell agreements only in the case of retirement planning, life doesn’t always cooperate. Illness, death, divorce and accidents can occur and they generally happen at the worst possible time. Emotions can run high and it’s difficult to make good decisions. However, if you can create a buy-sell agreement in the saner times, you can protect your interests and safeguard the life of your business.
Let’s look at how a buy-sell agreement will help provide a smooth transition, possibly help you avoid costly legal disputes among the company’s owners, and provide for heirs when the worst-case scenario actually happens.
If your partner dies without a buy-sell agreement, the business shares will likely pass to heirs per the partner’s will, living trust or state law.
If a buy-sell agreement is not in place, what do the heirs do about selling or keeping their shares? An immediate sale would put considerable strain on your working capital if you hadn’t prepared.
And what if the heirs decide to sell their shares to an outsider? Without a buy-sell agreement in place, you will have no say over who that might be.
If the heirs want to be a part of the business, ask yourself if they have the training needed or the respect of the remaining principals and employees. Are they qualified to work in the industry? This last question is especially important for licensed professional organizations such as medical and dental practices and law, engineering and accounting firms where licensure is a requirement for the job.
Your buy-sell agreement can address these types of problems in an orderly manner and help increase the likelihood that the business continues.
A buy-sell agreement is a contract between all the owners of the company or between the company and each owner. The business’s founders create the agreement after working with their accountant and attorney and it becomes part of the company’s by-laws, shareholder agreement or partnership agreement.
The provisions are typically included in the formation documents of a limited liability company. For a buy-sell agreement to work effectively three essential elements need to be present: share transfer restrictions, price determination and provisions to fund the buy-out.
Who can buy shares?
Share transfer restrictions, which are the heart of a buy-sell agreement, provide obligations and place restrictions on share disposition when an owner leaves the business. A buy-sell agreement’s requirements may be enacted if:
• An owner wants to retire or leave the business. Many times they offer to sell their shares to the remaining principals or to the company at a price determined in the buy-sell agreement.
• An outside partner makes a credible offer for one owner’s shares. That owner must first offer the shares to the company or its principals on the same terms. Many buy-sell agreements will restrict or prohibit the sale of shares to an outsider.
• When a principal dies, the company or the other shareholders can buy the deceased owner’s shares from the estate at the price determined in the agreement. Reciprocally, the estate must sell those shares back to the company at the determined price and not shop them around.
• In the case of divorce, the buy-sell agreement can restrict which spouse can own the company shares.
Without a predetermined price or formula for pricing the shares, buy-sell provisions are less useful. The price can be a fixed dollar amount or be determined by a formula. The most common formulas are:
• Book value determined by your assets minus your liabilities from the most recent balance sheet;
• Multiple earnings determined by a valuator multiplying last year’s earnings per share by a fixed number. This number will vary by industry;
• Percentage of gross income, which also varies by industry;
• Yearly valuation figures previously agreed upon;
• Outside appraisal by arbitrator, accountant or professional appraiser to establish share prices at the time of the buy-out.
Paying for a buy-out
Your buy-sell agreement needs to provide a source for the cash to buy shares from the principal or the estate. Many times this is accomplished through the purchase of life or disability insurance on the owners.
Life insurance funds provide immediate access to the cash in the case of a death and if planned properly, the proceeds may be income tax-free.
If you have more than a few shareholders, this can get very complicated because each owner owns and pays for a policy on each of the others. If, however, you structure your agreement so that the company buys an owner’s shares, then the company must apply for and pay the insurance premium on each principal. If one owner dies, the company then pays the estate with the insurance funds.
If there is no provision set up for the purchase of life insurance, the buy-sell agreement should spell out in detail the payment terms so that the company cash flow is not compromised by having to pay for the shares all at once.
Business owners would be wise to consult their CPA, estate planner and possibly their heirs while working with their attorney to write a buy-sell agreement. Planning ahead for likely events rather than reacting to a major change will make a difference in how the business functions and survives.
Chris Shorba, CPA, specializes in strategic consulting for privately held businesses and estate planning for high-wealth individuals for KDV, a CPA and business advisory firm with locations in the Twin Cities and St. Cloud: 763.537.3011; email@example.com; www.kdv.com