After putting considerable time and effort into building a business, you don’t want to risk it falling into the hands of someone who may not care for it. A buy-sell agreement is a form of business succession that allows businesses with multiple owners to specify how and when each owner will sell his or her business interest and at what price.
For businesses with multiple owners, this can help owners retain control of a business rather than having a portion of the business pass to the former business owner’s family, who may not be involved in day-to-day operations. By establishing a buy-sell agreement early on, you can eliminate the risk of an unexpected event throwing your business plans into disarray. Most buy-sell agreements provide for situations such as retirement, divorce, death or disability, all of which can affect how an owner’s business assets are handled. When set up correctly, a buy-sell agreement can help protect both business owners and the former business owner’s family.
The Basics of Buy-Sell Agreements
A chief concern among business owners is what will happen if one of the owners leaves the business—they may wonder how will it affect the business, the other owners and the former owner’s family. The remaining owners want to ensure continuity of ownership, and they want to avoid having ownership fall into the hands of the former owner’s potentially inexperienced family. In addition, they want to protect themselves and the company financially. On a personal level, owners also want to ensure that their families are financially secure and compensated fairly if something happens to them.
A buy-sell agreement can address all of these concerns. It is a contract among business owners, which, upon the death, disability, retirement or divorce of one of those owners, requires the remaining owners or the company itself to purchase that owner’s interest in the company, according to the agreed upon terms of the contract. In addition, the former owner’s family is required to comply by selling its inherited interest at a previously agreed upon price.
Buy-sell agreements can help business owners to do the following:
- Establish a valuation of a deceased owner’s interest in the business for estate tax purposes.
- Establish a mutually agreeable price and terms to reduce future potential litigation and friction.
- Facilitate a smooth transition of management.
- Ensure the family of the deceased owner receives cash instead of unmarketable stock.
Buy-Sell Agreement Triggers
Many events can cause a buy-sell agreement to go into effect, and it’s likely that each of these events will require slightly different sale conditions. Buy-sell agreements will usually specify restrictions and limitations for a variety of these triggering events in order to plan for all possible situations. Some events that might trigger a buy-sell agreement include the following:
Some events, such as death or resignation, would obviously require an owner to give up the entirety of his or her interest in a business. However, other events, such as divorce, may not affect the owner’s interest at all, but simply require the owner’s former spouse to sell any interest received in a divorce settlement back to the company. It’s important to think of all possible scenarios when establishing a buy-sell agreement—even those that may seem unlikely to occur.
Determining Business Value for a Buy-Sell Agreement
One of the most difficult parts of setting up a buy-sell agreement is determining how much your share of the business is worth. This requires maintaining a delicate balance of the compensation you or your family will receive for your share, while also giving your co-owners a fair price. Setting a dollar amount for your business interest in advance of an actual sale helps determine the most objective price for all.
Consider the following valuation methods for your buy-sell agreement:
- Prices for comparable businesses in your market
- Value of business assets, including liquidation value
- Historical earnings
- Future earnings
- Combination of business assets and earnings
Choosing a valuation method is a complicated process, and it is likely to require professional advice.
Funding a Buy-Sell Agreement
In order for the remaining owners to buy out a former owner’s business interest, they must have funds available. However, business owners may find themselves unable to afford the additional business interest when the time comes. To avoid this scenario, set up funding for the buy-sell agreement as soon as it is established.
There are various options for funding a buy-sell agreement, but some carry more risk than others. Some owners choose to open a company savings account in order to pay cash if the death of an owner occurs. The main risk with this strategy is the uncertainty of the future: what if a catastrophe happens the next week, or even the next year? Relying on this savings account presupposes that nothing will happen to the owners for many years while money accumulates in the account.
Another option, which also carries heavy risk, is to wait and simply take out a loan if something happens to one of the owners. This can create unnecessary financial risks for both the surviving owners and the company itself.
An option that carries less risk is using life insurance to fund a buy-sell agreement. It ensures that funds are immediately available when a death occurs; plus, death benefit proceeds are generally income-tax free. In addition, the funds used to buy the deceased’s share are purchased for pennies on the dollar and the premiums will likely be significantly lower than the cost of repaying loan interest.
When choosing the amount of insurance coverage needed to fund a buy-sell agreement, the coverage on your life should equal the value of your ownership interest. This ensures that when you die, there will be enough funding from the policy to pay for your full share of the business.
Since the value of the business is likely to change over time, consider specifying within the buy-sell agreement how that valuation difference will be handled in order to ensure that your family receives the full value of your business interest and that any excess proceeds will be divided correctly.
No matter what method you use to fund a buy-sell agreement, consider these three basic arrangements for structuring agreements:
1. Cross-purchase Plans
Under this type of plan, the owners enter into an agreement with each other. Each owner agrees to buy a share of the departing owner’s interest. If you are using life insurance to fund the agreement, each owner would purchase a life insurance policy on the other owners and be named the beneficiary of the policy. Upon the death of an owner, each surviving owner receives life insurance proceeds tax-free, heirs receive an agreed-upon payment for their business interest, and the surviving owner(s) use the proceeds from the life insurance policy to redeem the deceased owner’s interest in the company.
2. Entity Plans
In this type of agreement, the business, rather than the individual owners, is obligated to buy the interest of the departing owner. If using life insurance, the company purchases life insurance policies on each owner, naming the company as the beneficiary. When an owner dies, the company receives the life insurance proceeds and uses said proceeds to purchase the deceased owner’s business interest, while the heirs receive an agreed-upon payment for their business interest.
3. Wait-and-see Plans
This option is a hybrid of the previous two. It is used when owners are unsure if the business or the owners will buy the departing owner’s interest. Typically, the business is given the opportunity to buy it, and if it chooses not to, the remaining owners are given the opportunity. If the remaining owners choose not to buy the departing owner’s interest, due to financial circumstances or any other reason, the business is then obligated to buy the interest.
A buy-sell agreement can be essential to the survival and management of a company. By establishing a buy-sell agreement early on and reviewing it as your business changes, you can ensure the best possible outcome for your business, no matter what the future may bring.