Planning Ahead for Your Business: The Buy-Sell Agreement | Provider Insurance

Planning Ahead for Your Business: The Buy-Sell Agreement | Provider Insurance

June 14th, 2010 Posted in In The News

When a partner or owner dies or retires, a buy-sell agreement ensures that all parties get a fair price.

As a small business owner you probably want your business to be able to go on without you, but have you actually done the planning to make this a reality? Your business is a growing, ongoing operation, and also your major asset and income source. What is going to happen:

* When you are ready to retire?
* If pass away and your heirs are not interested or not suitable to operate the business?
* If you don’t want to end up in business with your partners’ heirs?
* If you are disabled and unable to participate in business operations?
* If you or a partner divorce or remarry?
* When a key person or partner leaves or dies?

In a series of three articles we’ll be giving you the information you need to create a successful business exit or transition plan. We’ll start with the basics—the buy-sell agreement and what happens without one. Next, we will look at ways to fund the agreement. Finally, we’ll cover methods for valuing your business and dealing with the departure of an owner.

Successful small business owners, even sole proprietors, need a succession plan, often called a buy-sell agreement. The requirements and triggers for this plan are normally contained in your partnership or shareholders’ agreement. Without such a plan, your business will quickly lose value if you or a co-owner dies, retires, quits, or becomes disabled.

Factoid

According to a survey of beneficiaries of business owners, only 21 percent had a formal plan to transfer their share of the business at their death or disability. Of the business owners who did have a plan, many have not updated their plan in years.*

* Source: http://southwestconstruction.com/opinions/finance/0404_opinion.asp (a McGraw-Hill publications)

A properly drafted buy-sell agreement helps ensure the business will retain its value and liquidity in the case of death, disability, retirement, or divorce of an owner or partner. The buy-sell agreement can guarantee there will be a buyer for a departing partner’s interests and creates a ready market for the sale of shares or a business interest—both are critical to retaining the full value of the business.

A cautionary tale:

Barbara Wells, an attorney with Minor & Brown, P.C. in Denver, offers the following example of why a written buy-sell agreement is so important: Two business owners enlisted a personal friend to help fund the startup of their manufacturing business. They knew that someday they would want to buy out the friend’s shares, but did not get a buy-sell agreement, because they “knew it would be okay since we’re all friends.”

The business became successful. The partners paid the investor dividends, but after a while they no longer needed the investor and offered him his original investment plus interest to buy back the investor’s share of the business. Naturally, the investor declined this none-to-generous offer. He pointed out that he had no obligation to sell—at any price. And, indeed, why would he give up those dividends?

These owners were lucky. They had zero leverage, but were finally able to negotiate a deal to buy out their (former) friend at a handsome premium over principle and interest.

What goes into a buy-sell agreement?

The agreement must be prepared by a business law attorney who specializes in this area. Do not try this at home! The agreement can include many things, but most importantly, it must specify the triggers that will activate the terms, the price of the business, the valuation formula, and the share for each owner.

Then you need to place a value on your business. The best way to do this is to work with a business valuation specialist. Some accountants are valuation specialists, too. For more information, talk to your accountant or look for evaluators in your area at these Web sites:

* National Association of Certified Valuation Analysts (www.nacva.com)
* Institute of Business Appraisers (www.go-iba.org).

It is essential that this valuation be done using methods acceptable to the Internal Revenue Service. The buy-sell document should also lay out a schedule to re-value the business every few years and to automatically increase the value to adjust for growth and inflation. There are four main structures. The highlights of each we will take up in the next section. You must also decide how to fund the buy-sell agreement and make sure that the structure, valuation, and funding approaches are tax-efficient and don’t trigger unwanted outcomes, such as exposure to the alternative minimum tax (AMT).

The types of buy-sell agreements

There are four main types of agreements:

* Cross-purchase
* Entity or stock redemption
* One-way
* Wait-and-see

The Cross-Purchase Agreement

In this structure, each owner/partner agrees to buy a predetermined portion of any other owner/partner’s business interest when a triggering event (retirement, death, disability, divorce, etc.) occurs. This is less complicated from a tax perspective, but more complicated when it comes to funding.

The Entity/Stock Redemption

This gives the entity (business) first right of refusal to buy the stock (interest) of an owner/partner when a triggering event takes place. This is more complicated from a tax perspective, but less complicated from a funding one.

The One-Way Agreement

This is for a sole owner and creates a contract with an outsider (perhaps a younger competitor) to buy the business when a triggering event takes place.

The Wait-and-See Agreement

Sometimes it is not clear whether the cross-purchase or entity/stock redemption structure makes the most sense. In this case the buy-sell agreement is structured to allow the actual choice to be made at a later date.

Tip

It is very important to understand the triggering events. There is a long list, but the main ones are: death of an owner, disability of an owner, sale of a business interest, divorce of an owner, or retirement of an owner.

Business succession and buy-out can be a very messy business. A small bit of planning and follow-through goes a long way towards ensuring you get the value out of your business when it’s time for someone to go.