Sep
Article By: Jeff Skolnick, CPA, M.S. Taxation
The purpose of a buy-sell agreement is to facilitate a change in ownership upon the occurrence of certain events. These events can either be voluntary, such as retirement or involuntary, such as death, disability, or the inability of a partner/shareholder/owner to meet his/her financial obligations.
Buy-sell agreements set a market for a Company. These agreements are generally used by privately held businesses which do not have a readily available market. In other words, selling shares in your business is not going to be quite as easy as selling shares of Microsoft or Facebook. It is not always practical to try to sell a privately held business and virtually impossible to sell a portion of a privately held business. How many people do you think will want to buy into a business where they become partners or shareholders with people they do not even know?
The buy-sell agreement either sets the price of the business or lays out the mechanism to determine such a value. Typically, these agreements will use one or more of a variety of methods to determine value. Value can be based on book value of the Company, some type of multiples of either revenue or earnings or through the use of a valuation expert.
Details are needed in the agreement even when using a valuation expert. Both the departing and remaining owner(s) may hire their own valuation experts, or they may mutually agree on a third party. It is important to remember that valuation is not an exact science and different experts may come up with different values. There must be a determination of how these potentially differing values will be utilized. Being able to determine the correct value of a Company is a major focus of a buy-sell agreement.
These agreements also allow the current owners to maintain control. In many situations, the remaining owner or owners would love to buy out a departed owner but may not have the wherewithal to do so. Additionally, there are very good reasons why a remaining owner wants to purchase the interest of a departed owner. Let’s take an example where two siblings are partners (Jack and Jill), and each is married. If one of the siblings passes away (Jack) and his interest passes to his spouse now Jill has become a partner with Jack’s spouse. They may or may not get along as well as the two siblings did, but what if Jack’s former spouse gets remarried? In this situation although Jill is not partners with this new spouse, that spouse may be chirping in the ear of Jack’s former spouse which can cause many complications.
Once the terms of the buy-sell agreement are determined very often, the owners will purchase life insurance policies on each other. These policies help to provide funds if one owner passes away. The policy will pay the remaining owner or owners who can then use these funds to purchase the interest of the diseased owner from his/her family.
Let’s look at an example. If there are two partners, Nancy and Jim that each own 50% of a Company valued at $1,000,000, then how would life insurance be used to finance a buy-sell agreement? Each partner would have a $500,000 policy on the life of the other partner. Let’s move forward here and assume that Jim dies. Nancy will collect $500,000 from the insurance policy on Jim’s life which she would then use to purchase Jim’s interest from his beneficiaries.
In the case of an owner who has the left the Company but not passed away, payment methods aside from using life insurance proceeds are necessary. The agreement should spell out the terms if the buyout is to be financed. Terms would be similar to those determined in any financing situation, amount of down payment, amount of years for the payout, method to determine an applicable interest rate and consequences of not abiding by the payment terms.
It is also important to review buy-sell agreements on a regular basis. Owners want to make sure from time to time that the terms of the agreement still make sense. If you entered into a buy-sell agreement when your business first opened but haven’t looked at the agreement in 25 years things may have changed. Remember my earlier example? You don’t want a situation where each partner has taken out a $500,00 life insurance policy on the other partner but now the business is worth $5,000,000 and not $1,000,000. I encourage at least a quick review every few years to make sure everyone is happy with the way things will transpire if the agreement is invoked.
While not the sexiest of all business agreements, a well-crafted buy-sell agreement that is drafted with some effort and foresight will allow remaining owners to maintain their ownership and allow departed members or their families to be reasonably compensated when relinquishing their ownership. I believe that when drafting a buy-sell agreement that the assistance of professionals (attorneys and possibly accountants and valuation experts) is essential.