The Importance of Buy-Sell Agreements
Any time there is a business with multiple owners, there is a decent chance that one of those owners, eventually, will no longer be involved with the business due to death, bankruptcy, divorce, or choice. It is imperative for business owners to plan for this well in advance. Sometimes, a co-founder may become unhinged and run off to the Galapagos islands while selling his half of the company to your estranged husband, or something. No young business needs that kind of uncertainty or difficulty. The best way to prepare for this is with a buy-sell agreement. A buy-sell agreement is essentially a binding contract between business owners (think of it like a pre-nuptial agreement) that determines who can buy, and for what price/value, the departing owner’s share of the company. A buy-sell agreement may also specify procedures through which the owners may resolve disagreements amongst the owners.
Despite the wide-spread use of buy-sell agreements, a good business advisor can often add value to the business by identifying and addressing one of several common mistakes associated with the agreements themselves. Creating the appropriate buy-sell agreement can be tricky and it is important for business owners to avoid these common mistakes in buy-sell agreements:
Mistake No. 1: Fixed Valuation
It is easy, and therefore common, for buy-sell agreements to reference a fixed-dollar amount or specified formula as the determinant of the acquisition price in the event that an owner departs the business or dies. When a buy-sell agreement does include a fixed-dollar amount, it will typically call for a review/update every year or so. Issues with this type of valuation can arise for at least one of two reasons.
First, buy-sell agreements are usually drafted and agreed upon when the business is originally formed. Thus, it is common for the agreement to be stashed away shortly thereafter, never to be seen again until a triggering event occurs. If the business has prospered by the time the triggering event occurs, the valuation would likely be far off the mark. To protect against this, the agreement will occasionally require the owners to negotiate an agreed upon price prior to the sale. Sometimes, however, the dynamics have changed and the pricing agreed upon may end up way off what either party believes is fair.
Second, even if a buy-sell agreement references a formula through which to value the company (rather than a fixed price), the appropriateness of the formula may change over time. For instance, a buy-sell agreement that references the “book value” as the purchase price may be appropriate for a startup business with no earnings history, but would likely understate the fair market value for a growing or mature business. Additionally, even if a more sophisticated formula is required in the agreement (e.g., capitalization of net earnings), approaches may vary depending on the intentions of the parties. For instance, a sale to a strategic buyer may differ in price than a sale to a financial buyer.
Solution: Advisors need to emphasize the importance of keeping fixed-price valuations up-to-date and advise clients to have specialists review valuation formulas to determine if the specified valuation remains appropriate given where the parties stand today.
Mistake No. 2: Failing to Fund
Another major mistake founders make with buy-sell agreements involves the failure to adequately fund/properly arrange funding for the agreement. Closely-held businesses are often vulnerable to under capitalization, and thus, a shortage of capital necessary to implement buy-outs of a departing owner’s interest. Self-financing is common among new and closely held businesses, and cash can be tight; during the startup/growth phases, available cash flow is usually dedicated to product and service development and overhead. Without proper funding, survivors of the business may be unable to meet the financial commitments under the buy-sell agreement, leaving the departing owner or a deceased owner’s heirs left out to dry.
A common approach to funding under the buy-sell agreement is to purchase life insurance or disability income insurance on the owners such that if a triggering event occurs (death or disability), then the parties have adequate funding under the agreement. The parties to this type of arrangement need to keep in mind, though, that as the business grows over time, the face amount of the insurance policy may become inadequate. Many life insurance policies can be structured such that the death benefit grows overtime without additional underwriting if the policies perform better than guaranteed. Similarly, disability income insurance policies can be purchased with inflation protection, which allows the benefit to increase along with the Consumer Price Index (CPI).
One thing to keep in mind for this type of arrangement in buy-sell agreements is the ownership and beneficiary designation. Generally, if the buy-sell agreement is an “entity agreement,” the business entity will be obligated to buy out the departing owner’s interest and should be on the policy. On the other hand, if the agreement is a “cross-purchase agreement,” the remaining owner(s) will need to apply for and own the insurance policy on the lives of the departing business owner(s) with themselves as the beneficiaries. It can get tricky when a business owns the insurance and uses the proceeds to fulfill the obligations of an owner’s cross-purchase agreement because the distribution of the proceeds may be treated as a taxable dividend in the case of a C-corporation, or carry out taxable retained earnings and profits in the case of an S-corporation. Normally, life insurance proceeds are tax fee, so it is important for owners using this type of buy-sell agreement funding to consult with an experienced tax attorney and/or life insurance specialist.
Solution: It should be determined if insurance for funding has been acquired, if it remains adequate with the passage of time, and if the ownership and beneficiaries are properly named.
Mistake No. 3: Improper Terms
Buy-sell agreements typically fall into one of three categories: the agreement calls for a mandatory sale upon the occurrence of a triggering event; a “put” by the departing founder; or a right of first refusal on behalf of the remaining founders.
When a buy-sell agreement falls into the first category, the affected owner must offer his share of the business upon the occurrence of a triggering event (e.g. bankruptcy). A mandatory buy-sell ensures that the remaining owners maintain control of the business.
If a buy-sell agreement provides for a “put,” the departing owner may offer his or her interest to the survivors, who must then purchase it if she does so. This type of arrangement favors the departing founder and the marketability of her interest over control and continuity of the remaining founders.
Also, this type of arrangement can put a super-majority owner in the driver’s seat to the detriment of the minority owners. For instance, if the super-majority owner can get a better offer from outsiders she is free to take it; if not, she can force the other owners into a buy-out and to pay an above market price. This arrangement may put minority owners in a tough place if they do not have the capital to execute on the super-majority owner’s put and they cannot find a third-party market for these interests.
When a buy-sell agreement provides for a right of first refusal, the affected owner who is looking to leave the business must first offer her interests to the other owners, who may accept or refuse the offer. If the remaining owners refuse, the departing owner is free to sell her interests to outsiders. This type of arrangement favors control and continuity over marketability because minority interests in a privately-held business are particularly hard to market and because such interests often do not receive cash distributions of profits, a deceased owner’s heirs or a disabled owner could be left holding a valuable, but non-income producing asset, if the other owners choose not to go through with the buyout.
Solution: Advisors need to review terms of buy-out agreements with owners to determine if the terms as originally drafted continue to meet changing needs. Owners should consider the terms from both sides of the equation.
Buy-sell agreements are a must-have when it comes to multiple-owner businesses. Change can be great for success and growth, but when change comes in its worst form, make sure you and your business are adequately protected.
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