Does My Business Need A Buy-Sell Agreement?
By Bret Harding
First of let me say “YES” a buy-sell agreement is a critical component of any businesses continuation plan. This becomes especially true if the business has more than one founder or has recently brought additional “key stakeholders” into the business. The reason for a buy-sell agreement is to address important business concerns like “what would happen to the business if one of the owners passed away, left the company, or became disabled?” In almost every instant the surviving owners generally want to ensure a continuity of ownership and management without having the departing owner’s successor thrust upon them. Nor do they want to compromise the liquidity needs of the business by funding a significant buyout. Disabled or deceased owners would want their families compensated fairly for their share of the business. A properly drafted buy-sell agreement can achieve all of these goals by:
- Providing that upon the occurrence of a specified “triggering event,” owners are guaranteed that their interest in the business will be purchased;
- Providing that the owner’s interest must be sold to the company, the remaining owners, or a combination of the two;
- Providing a mechanism whereby the purchase price may be determined by market conditions in existence upon the occurrence of the event;
- Providing a funding source, primarily through insurance policies, so that the liquidity needs of the business or its owners will not be onerous; and
- Establishing a valuation of a deceased owner’s interest in the business for estate tax purposes.
What are Triggering Events?
An integral part of any buy-sell agreement is to specify what type of events will trigger a mandatory or optional buyout of an owner’s interest by the other owners or the entity itself. The most common of these triggering events are described below.
Death or disability. This event is almost universally provided for in the buy-sell agreement. Terms of this buyout will include the determination of disability, the time for payment to the owner or the owner’s estate, whether the entity or the surviving shareholders have the obligation to purchase the interest, and whether a funding mechanism, such as life or disability insurance, should be maintained by the entity or the owners personally.
The desire to sell the interest to a third party. The agreement should provide that the terms of the potential sale be presented to the other owners and that they be given the option of:
- matching the offer made by the outsider;
- purchasing the shares in accordance with the valuation method and payment terms provided for within the agreement;
- having the entity repurchase the shares issued in accordance with the valuation method provided for within the agreement; or
- allowing the sale to be effectuated to the third party.
Retirement of an owner. While a sale to a third party would provide the other owners an optional right to purchase the selling owner’s interest, an owner’s retirement will generally trigger a mandatory buyout. Of course, the conditions under which an owner may have the right to retire so that the remaining owners, or the entity, would be compelled to buy that owner out are often a point of negotiation. Once again, valuation methods and payment terms will be important issues, because there are no outside funding mechanisms, such as life or disability insurance, available to bear the cost.
Owner’s divorce or bankruptcy. Either of these events can subject the business to interference from outsiders. To prevent this, the other owners should have the option to compel the affected owner to sell his shares to the remaining owners or the entity itself, in accordance with the payment terms and valuation methods (to be discussed later.)
Types of Funding Arrangements for a Triggering Event
Cross-purchase arrangements. Under this plan, each surviving owner of a business becomes personally obligated to purchase the departing owner’s interest. To provide the surviving owners with liquidity, each owner would own an insurance policy on the lives of the other owners. The proceeds of the life insurance policy would be received tax-free by the survivor and then used to purchase the deceased owner’s interest so that the survivor’s ownership interest remains the same in relation to the other surviving owners.
Entity redemption arrangement. Under this plan, the business entity is obligated to purchase the owner’s interest. To minimize the impact this might have on the entity’s liquidity needs, the entity can purchase life insurance policies on each owner. The business names itself as the beneficiary of each policy, and the face amount of the policy will be equal to the agreed-upon purchase price set in the buy-sell agreement. The proceeds should be received by the entity free of ordinary income taxes, pursuant to IRC section 101. This would be followed by a purchase of the owner’s interest by the entity with the life insurance proceeds.
Types of Valuation Methods
The goal of a valuation method is to best approximate the business’s actual fair market value. Fair market value has been defined as the price at which property passes between a willing buyer and seller, neither under any compulsion to buy or sell, and both with knowledge of all relevant facts. Of course, where less than the entire ownership interest is being acquired, there might be discounts to reflect the lack of control or lack of marketability. Some of the more common business valuation methods are summarized below.
Book value. This method, also known as the net asset value method, is based on the net worth (assets-liabilities) of a business on a company’s books and records for accounting purposes. While this method is easy and relatively inexpensive to ascertain, book values are based on historical-cost principles, which frequently become unrealistic over time, especially for assets such as real estate, patents, and goodwill. Some modifications of the book value method include the tangible book value method, which basically includes only assets, such as cash, inventory, equipment, and real estate. Economic book value would entail an appraiser in an effort to update the value of assets to their current market value.
Capitalization of earnings. This method attempts to value a business by estimating an acceptable rate of return on a purchaser’s investment in light of the risk associated with the particular business, and then applying such a rate of return to the anticipated earnings stream of the business, based on its average net earnings (after operating expenses) over the last few years. Any potential buyers would obviously be looking at a rate of return on their investment well in excess of the rate of return on a much safer alternative, such as a certificate of deposit or a blue-chip stock. Rates of 20% or more are not uncommon for small closely held businesses.
An interesting variation on capitalization of earnings is known as the excess earning method. This method, frequently used when a business has substantial receivables, inventory, property, and plant and equipment, seeks to separate a desired rate of return on a company’s tangible assets from its total earnings in order to derive “excess earnings.” The excess earnings is then multiplied by a factor (the higher the risk, the larger the factor), and this amount is then added to the fair market value of the tangible assets to determine the purchase price.
A Buy/sell agreement can be an effective tool to allow a business to continue after a triggering event. A buy-sell agreement funded with life insurance can, in the event of death of an owner, provide the surviving owners the funds necessary to meet the terms of the agreement. Executing a carefully planned buy-sell agreement will assure owners in a closely held business that their interest in the business they built is secure regardless of any unforeseen circumstances. In many cases this can be accomplished without putting excessive strain on the business’s cash flow, ensuring that the business and its remaining owners continue to succeed as well. The actual decision to implement a Buy/sell agreement is a planning decision that should include the owners and their professional advisors.
Utah Insurance Solutions specializes in helping business owners put in-place Buy-Sell Agreements that work. We ensure the agreement is executed properly, and will hold up in a court of law should a triggering event occur.