Unexpected events happen in business, just as in all other aspects of life. The death, disability, retirement, or “divorce” of business owners can jeopardize a healthy business or send it into a financial tailspin. That’s why it’s so important for the owners to create a buy-sell agreement that spells out what will happen under certain scenarios.
Buy-sell agreements cover, among other things, who buys, who sells, under what conditions, at what price, on what terms, and how the transaction is funded. They allow owners to make these strategic decisions in advance, long before a crisis occurs. By setting forth the terms and conditions for buying out an owner’s interest, they eliminate or at least reduce the turmoil of a key risk to the health of the business.
An effective buy-sell agreement can help the owners make a successful transition, while maintaining the ongoing business operations and survival. For example, the two owners of a grocery business corporation signed a buy-sell agreement after their father, the company founder, passed away, and modified it several times through the years. When one of the owners accidently died, his shares were purchased from his estate using life insurance proceeds, providing liquidity to his surviving spouse. In turn, the surviving owner was able to become the 100% owner of the company and eventually sold/distributed a portion of his shares to his children, who remained active and took over the business.
That’s a far better outcome than a deadlock or prolonged struggle for control among the surviving owner and the spouse of the deceased owner—a frequent occurrence without a plan and effective buy-sell agreement. For simplicity, assume you are the surviving co-owner suddenly forced to deal with the spouse or children of your late partner, who now holds a 50% inherited equity interest. That family may not understand the business or its market, be qualified (or want to) work in the business, and may hold different values or beliefs than you. If co-ownership continues, and you can’t find a way to work together effectively, your business will be in deep trouble--sooner rather than later.
Consider the Scenarios
Qualified business lawyers can draft agreements that make for orderly exits of the owners, regardless of whether the business is a corporation, limited liability company (LLC), or a partnership. Because there are many “moving parts” in a typical buy-sell agreement, it’s important to have a team of experts involved, including an accountant, insurance expert, and estate-planning attorney as members.
If a buy-sell agreement is not yet in place, sit down with your business attorney and discuss how to handle various exit scenarios:
• How could the business ownership be made secure if an owner suddenly passed away?
• What if an owner announced plans to retire right away or in a few years?
• Is there a mechanism in place to purchase the shares of an owner who departs for other reasons—voluntarily or involuntarily?
• How can these transactions be financed without endangering the cash flow of the business or its remaining owners?
If your business already has an agreement in place, take time to review it periodically and consider the various scenarios and solutions. After all, the business world continues to change, as do the goals of the owners and the value of the company.
Whether creating a new document or modifying an existing arrangement, it’s important to understand that each buy-sell agreement is different. The number of owners, their percentage interests and talents/contributions to the business, their ages, their goals in life, and even their personalities can affect the planning process. The size and scope of the business also needs to be considered. For instance, it’s usually much easier to address a business that is more passive, such as a rental real estate management company, where the day-to-day issues involve signing leases and sending out maintenance requests, than to run a multistore retail chain, a five-star resort, or a startup biotech company, to name just a few examples. Also, the professionals owning an accounting, law, medical, or dental practice may also face licensing limitations or other requirements limiting their ability to sell or convey their shares to a non-professional.
In some cases, the best option for exit planning is a stock redemption type agreement, where the company buys the interest of an owner who dies or retires. Another approach is a cross-purchase agreement, where one or more of the remaining owners buy the departing owner’s interest. Of course, there can be other solutions as well, such as a hybrid with the business buying part of the interest and the remaining owners purchasing the balance. Perhaps some or all of the interest of the departed owner is allowed to remain in her hands, or the hands of her family, with changes in voting rights and management authority.
These business agreements should be integrated with individual and family estate plans—a particularly important consideration for succession planning if members of the “younger generation” are active in the business.
Using Insurance to Fund Buy-Sell Agreements
Because implementing a buy-sell transaction can create an unexpected drain on the financial resources of the business or the remaining owners, insurance is a common funding vehicle.
A common structure has the business purchasing a life insurance policy on each owner, naming the business the beneficiary. The business pays the premiums. When an owner dies, the proceeds from the policy (some of which may also be designated as “key man” insurance to help the business through the difficult time) are used to redeem the interest from the deceased owner’s estate. It’s essential, however, for the ownership and objectives of the insurance policies to align with the buy-sell agreement. For instance, if not properly coordinated a policy may pay the death benefit to the surviving owner without a corresponding contractual obligation to use the money to purchase the surviving spouse’s interest. That would give the owner a cash windfall and leave the spouse with an illiquid interest in the business.
While the most common focus is on life insurance as a funding solution due to its ready availability and generally reasonable cost, there is actually a much higher risk of an owner suffering a disability, temporary or permanent, during the working-age years before retirement. What would happen to the business if the “rainmaker” owner is in a car accident and can’t work for six months? What if a chronic disease like cancer makes it difficult for an owner to devote more than a few hours a day to the business? What if there is a disagreement among the owners over whether an owner is actually disabled?
Because of the statistically higher prevalence of disability—and the many shades of gray involved in a disability claim—buy-sell agreements should provide specific mechanisms that cover these types of problematic scenarios. Funding considerations should also be addressed, since it’s usually far more expensive to insure against disability than death.
Other Funding Options
While insurance can help in many situations, buy-sell agreements should also include provisions for funding other types of exit for which insurance is not available or cost prohibitive. What if the owner simply wants to sell her interest or is forced to sell because of ill health or personal finances? How will the business find enough cash to retain control of those shares in order to avoid having the shareholder sell to an outsider?
A common technique is to give the business a right of first refusal to buy the departing owner’s interest under terms and conditions contained in the agreement. While an owner might prefer a lump-sum payment, the most practical approach from the business standpoint is to structure an installment purchase plan over several years. Reducing those monthly or quarterly payments to the exiting owner is particularly important if that vacated position needs to be filled right away. After all, it can be difficult to pay the replacement a high salary while making a substantial payment.
Depending on the amount of the owners’ equity and the cash flow requirements of the business, the buyout installment payments could be stretched out over 5, 10, or 15 years, with a reasonable interest rate applied to the balance. If a second owner leaves during that timeframe, the payments to the first departing owner could be reduced to avoid an onerous expense to the business. That’s just one of the nuances in drafting and funding this type of agreement.
A well-crafted buy-sell agreement can also provide a financial incentive for an owner to work until a specified retirement milestone, rather than leave early. If one of the owners makes an abrupt departure, the agreement can provide for a reduction in the buyout price.
Finally, business owners should consider the tax implications when drafting and funding their buy-sell agreements. The personal finances of individual owners may dictate the most effective approaches for minimizing potential income and estate tax liabilities.
As the nation’s economy recovers and many businesses dust off their growth plans, now is an excellent time to create or revisit buy-sell agreements. After all, there’s a lot of truth to the old adage, “An ounce of prevention is worth a pound of cure.”