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Got a Business Partner? Get a Buy-Sell Agreement

If you are a partner, member or shareholder in a company that has multiple owners, having a properly drafted buy-sell agreement is an absolute necessity

A buy-sell agreement is a contract among co-owners that sets forth what will happen when certain “triggering events” occur. It usually states who may purchase a departing owner’s share, how the purchase will be made, and for how much. It will typically also describe how to establish the company's value if a sale occurs due to one or more “triggering events.”

Ideally, the owners create their buy-sell agreement at the business’s inception, when they are on good terms and before the occurrence of a triggering event (discussed below). Here is a brief list of key points to consider in creating or critiquing a buy-sell agreement.

Triggering Events

Most buy-sell documents come into play if one the owners passes away, becomes disabled, retires, divorces, files for bankruptcy, is convicted of a crime, or wishes to sell their interest in the business. Addressing the marital divorce of an owner is especially important in community property states such as Arizona, where the spouse could be entitled to an undivided half of the couple’s ownership interest.

Mandatory or Optional Buy-Out

Many buy-sell documents provide a mandatory buy-out of a deceased owner’s interest in the company. That ensures that a market will exist for the owner’s business interest upon his or her death, particularly a “minority” interest (i.e., less than 50% ownership). It also assures that the remaining owners will not be saddled with new co-owners (e.g., the deceased owner’s spouse or heirs), with whom they might not want to be in business. In some cases, where ownership is entirely within a family, there may be an intent to retain the ownership within the family of the deceased owner, in which case the agreement is drafted in optional form, rather than requiring a mandatory buy out. In the event of an owner’s disability, particularly if that owner is active in the business, a buy-out may also be mandatory by the other owners, or perhaps optional if the now-disabled owner was not active in the business.

Form of Purchase

In general, buy-sell agreements are drafted in two forms: a “redemption” (also known as an “entity buy-out”) or a “cross-purchase” arrangement. In a redemption agreement, the business itself purchases the ownership of the deceased or departed owner; under a cross-purchase arrangement, the remaining owners make the purchase.

Whether the purchase is made by the business or by the other owners, funding the purchase can pose a serious cash drain, which can be avoided through the purchase of insurance. In many cases, insurance policies on the lives of one or more owners can provide some or all of the cash resources needed to purchase a departing owner’s interest. While there is a real cost to using life insurance, the alternatives may be even more costly. Funding a purchase in the absence of insurance can cash-strap your company or force it to take on substantial debt.

Ownership of the insurance policies depends largely on whether the purchase will be made by the business or by the remaining owners:

  • In a redemption arrangement, the business would own the insurance policies on the lives of the owners, the death benefit of which would then be used to redeem the deceased owner’s ownership interest.

  • In a cross-purchase agreement, the business is not directly involved; rather, each owner buys a policy on the life of every other owner, and then uses the death benefit to buy the deceased owner’s interest pursuant to the terms of the buy-sell.

Establishing a Value

Business valuation is one of the more important and complex issues related to crafting an effective buy-sell agreement. Some agreements will attempt to peg a price annually, with each owner signing off on the agreed annual valuation. While this assures that a current and realistic business value is used, it is easy for this annual price setting to be overlooked and become obsolete.

A better (but less than ideal) buy-sell provision is to define a formula approach to business valuation. Most formulas start with book value and make adjustments for the appraised value of specified hard assets and, possibly, goodwill. Other formulas will peg to multiples of earnings or income capitalization calculations. The tricky part of the formula approach is that there are many types of formulas, only one or two of which may actually apply to the type of company, the owners’ goals and other considerations, and all are vulnerable to challenges by the IRS.

In most cases, only the involvement of a business valuation professional will satisfy the desires of the owners and the demands of the tax authorities.

•  See also: “Addressing Valuation Issues Is Essential to an Effective Buy-Sell Agreement,” by Kotzin Valuation Partners

Conclusion

Buy-sell agreements can be invaluable in eliminating disputes and solving the tough questions after a triggering event has occurred. From time to time, having your buy-sell agreement reviewed by an experienced business attorney to assure that all the bases are covered can be a valuable ounce of prevention. For assistance in creating or reviewing your company’s buy-sell agreement, contact Ron Adams (480-345-8845 or email).