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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.
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
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
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).