BY REBECCA PAVESE
Even if not everyone has a will, most people understand why they should. But knowing how a business will go on without an owner or a partner can be just as important.
Unfortunately, many business owners neglect this important task.
A buy-sell agreement, despite the name, is not a mechanism for selling a business. It is a contract among the owners of a business or between the owners and the entity itself, which sets out the rules for handling certain specific, future events — usually an owner’s departure, planned or unplanned.
The agreement governs how to handle the interests of proprietors, partners or shareholders in the event that they can no longer work due to circumstances such as disability, retirement or death. While it is most often used in partnerships, privately owned companies or closely held corporations, a buy-sell agreement can be useful even for sole proprietors if the owner intends for a key employee or family member to take over the business one day.
Business owners gain a variety of benefits from entering into a buy-sell agreement. First, it can establish in advance a fair formula for valuing a share of the business. If one of the owners wishes to leave and the remaining owner or owners wish to buy the departing individual’s share, they will have competing interests regarding valuation in the moment. If they agree in advance, it is less likely anyone will feel unfairly treated.
Business co-owners may also wish to ensure that no one sells their stake in the business to a third party who is an undesirable or impractical partner. A typical buy-sell agreement gives the business, the owners or both a right of first refusal on certain proposed transfers of a stake in the enterprise. This means owners are more likely to keep control of the business, even if an individual with a large stake chooses to leave. Similarly, an agreement could stipulate that stakeholders in a closely held business must sell their shares back to the business when they exit.
Buy-sell agreements can also be useful in creating liquidity in the event of an owner’s departure, especially if it is unexpected. The agreement can ensure the withdrawing owner — or a deceased owner’s heirs — will have a market for a stake in the business that might not otherwise exist.
ELEMENTS OF A GOOD AGREEMENT
Drafting a buy-sell agreement early in the life of a business is important because it allows partners or co-owners to discuss contingencies such as a stakeholder’s death, disability or retirement. It also creates a way to guard against possible but less certain future scenarios such as a serious argument between stakeholders, an owner’s divorce or bankruptcy, or a partner using a stake in the business as collateral and then defaulting on the loan. By the time any of these situations occur, emotions are likely to run high. Setting up a plan in advance can not only safeguard the business but also reduce stress on owners during potentially trying circumstances.
Revisiting business succession plans every three to five years is a good idea, though owners should also reassess any time the business experiences a major change, such as rapid growth, the addition or departure of an owner or major stakeholder, or substantial changes to the business model.
When business owners create — and subsequently revisit — a buy-sell agreement, they should gather a team of professionals to help. This team should include an experienced lawyer, an accountant, a tax expert and, potentially, a valuation professional. (Sometimes a single individual may fulfill more than one of these roles.) Depending on the circumstances, owners may also want to involve their personal estate planning professional or financial planner.
A valuation professional is a good addition to the team because valuing the business is both a crucial part of a good buy-sell agreement and a complicated undertaking. Some buy-sell agreements include a specific formula to determine the value of a stake in the business. Others simply include a clause specifying that a valuation expert will assess the business at the appropriate time when an owner leaves.
Regardless of the formula or expert involved, the most important thing is for owners to agree on a valuation method in advance.
In addition to specifying a valuation method, a buy-sell agreement should include rules for who can buy and sell stakes in the business and under what circumstances. For instance, the founder of a family business may want to ensure that the enterprise stays partly or completely in the hands of family members or winds up there in the future. In many cases, a purchaser will be the other owners, the business itself or some combination of these two.
Because issues like death, divorce or bankruptcy cannot always be anticipated, rules about funding are also an important part of a buy-sell agreement. Agreements should specify how the business will fund a buyout of a departing owner. Specificity allows the business to plan realistically for future obligations. Requiring an immediate lump-sum buyout can make buying back an interest challenging or even impossible for some businesses, so many agreements provide for a down payment followed by installments over a few years at a reasonable rate of interest.
In some businesses, especially partnerships, co-owners purchase life insurance policies on one another — or the business purchases policies insuring key personnel — in order to fund buyouts of an owner’s heirs in the case of his or her unexpected death. This technique can become expensive with larger numbers of shareholders, so it is not right for every business, but it is a common way to fund a buy-sell agreement among a few key individuals.
While buy-sell agreements primarily address nontax goals, owners should keep tax obligations in mind when creating them. Funding concerns extend to how the business will pay the Internal Revenue Service, not only the seller.
The best buy-sell agreement is one that must be tailored to fit particular business needs and long-term goals. With some professional help and foresight, business owners can avoid unpleasant surprises when, inevitably, one of their number goes his or her own way.
Rebecca Pavese, CPA, is a financial planner and portfolio manager with Palisades Hudson Financial Group’s Atlanta office. The firm’s northeast office is in Stamford at First Stamford Place. Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager with $1.4 billion under management. It offers financial planning, wealth management and tax services. Visit palisadeshudson.com.