Buy Sell Agreements
A chief concern of the owners of a closely held business entity is what would happen to the business entity if one of the owners becomes disabled, dies, desires to sell to a third party non-owner, retires, becomes divorced or bankrupt, or changes employment. A properly drawn Buy-Sell Agreement will address these scenarios. In so doing, the Buy-Sell Agreement will accomplish two important goals: 1) ensure the continuity of ownership and management of the business entity without have the departing owner's successor thrust upon the remaining owners, and 2) provide a retiring, disabled or deceased owner and family fair compensation for such owner's share of the business entity, all without compromising the liquidity needs of the business entity. A Buy-Sell Agreement will also establish the value of the business interest of a deceased owner for estate tax purposes.
Triggering Events What type of situations will cause a mandatory or optional buyout of an owner's interest by the business entity or other owners under the terms of a Buy-Sell Agreement? Some common triggering events are:
Death or Disability. The death or disability of an owner usually causes a buyout under the terms of a Buy-Sell Agreement. Terms of the Buy-Sell Agreement will include how a disability is determined, valuation of the ownership interest, the terms of payment to the owner or the owner's estate, whether the entity or the surviving owners have the obligation to purchase the interest, and whether a funding mechanism, such as life or disability insurance, should be maintained by the business entity or the owners personally to provide liquidity for such a buyout.
Desire to Sell Ownership Interest to a Third Party. The desire of an owner to sell an interest in the business entity to a third party non-owner almost always results in the business entity or the non-selling owners having the option to purchase the interest of the selling owner. The Buy-Sell Agreement will require the terms of the potential sale to the third party non-owner to be presented to the business entity and other owners, and they be given the option of:
- matching the offer made by the third party non-owner;
- having the non-selling owners purchase the interest in accordance with the valuation method and payment terms provided for in the Buy-Sell Agreement;
- having the business entity repurchase the interest in accordance with the valuation method and payment terms provided for in the Buy-Sell Agreement; or
- allowing the sale to the third party non-owner to be consummated.
Requested Buyout. In a closely held business entity with a small number of owners, an owner may desire to be bought out prior to retirement or the occurrence of a different triggering event but there is no market for the sale of his or her interest. A Buy-Sell Agreement can resolve this situation by providing for a buyout under defined terms including valuation of the ownership interest and payment terms. In the case of only two owners, the Agreement will often provide that the selling owner state in writing a per share or per unit dollar amount that he or she is willing to sell his or her interest in the business entity, and the other owner than having the option of either purchasing the selling owner's interest at such dollar amount or requiring the selling owner to purchase the non-selling owner's interest at such per share or per unit dollar amount.
Retirement of an owner. An owner's retirement will generally cause a mandatory buyout of the retiring owner's interest. Usually there are no outside funding mechanisms such as insurance to fund the buyout of a retiring owner, so the Buy-Sell Agreement must define a qualifying retirement, the valuation method and payment terms. The payment terms will often provide for a down payment with installment payments over a number of years at a defined rate of interest.
Owner's divorce or bankruptcy. The divorce or bankruptcy of an owner can result in the owner's interest passing to a third party non-owner, especially in a divorce situation in community property states such as Nevada, California and Arizona. Such a divorce or bankruptcy often will result in the business entity or the other owners having the option to purchase the interest of the divorcing or bankrupt owner. The Buy-Sell Agreement will give the business entity and the other owners the option to compel the affected owner to sell his or her interest to the business entity or the other owners in accordance with the valuation method and payment terms provided for in the Buy-Sell Agreement.
Change In Employment. When an employee-owner changes employment and is no longer employed by the business entity, this will often cause a mandatory buyout of the interest of the former employee-owner. This may be coupled with a covenant not to compete that is included in the Buy-Sell Agreement or a covenant not to compete that is included in the employment agreement between the employee-owner and the business entity.
Valuation The valuation of the interest being purchased under the terms of a Buy-Sell Agreement is a critical issue for both the selling owner and the purchasing business entity or other owners. The valuation method must balance the competing interests of the selling owner, who desires a high valuation, and the purchasing business entity or other owners, who desire a low valuation. A Buy-Sell Agreement that provides for an agreed upon valuation method will eliminate conflict, disagreement and possible litigation between the parties when a triggering event occurs. Some common valuation methods are:
Book Value. This valuation method is based on the net worth of a business entity as reflected on its books and records for accounting purposes. Generally speaking, this valuation method is often on the low end, especially regarding the real estate and goodwill of the business entity. To compensate for this, a multiple of book value method takes into account intangible assets that add to a company's worth such as goodwill, patents, copyrights, brand names and trade names.
Appraisal. This valuation method entails the appraisal of the assets of the business entity at their current market value event less liabilities of the business entity as of the time of the triggering event. Often the Buy-Sell Agreement will provide that each side shall have the right to select a professional business entity appraiser if they are unable to agree on one appraiser with a blending or selection formula if the two appraisers do not agree on the value.
Capitalization of earnings. This method applies a rate of return to the anticipated earnings stream of the business entity based on its average net earnings over a number of past years.
Annual Agreed to Value. This method uses a valuation that is annually agreed to by the owners in writing. A common problem with this valuation method is the failure of the owners to do so on an annual basis. A properly drawn Buy-Sell Agreement will anticipate this problem and provide for an alternate valuation method in the event the owners fail to update the valuation for a certain number of years.
Sales-multiple valuation. This valuation method is often used for a service business entity that does not have significant hard assets. The method involves the application of an industry specific multiplier to an average stream of revenue over a number of years.
Funding a Buy-Sell Agreement The funding of a Buy-Sell Agreement is also a critical issue for the parties. The selling owner wants to insure there will be funds to finance the buyout while the purchasing business entity and remaining owners want the ability to consummate the buyout without compromising the liquidity of the business entity or themselves. Some common funding mechanisms are:
Disability/Life Insurance.
For a disabled owner, disability insurance can be used to fund a buyout, and for a deceased owner, life insurance can be used to fund the buyout.
The two most common types of Buy-Sell Agreements utilizing life insurance are cross-purchase agreements and redemption agreements. Under a cross-purchase agreement, each owner of the business entity becomes personally obligated to purchase the departing owner's interest. Each owner owns an insurance policy on the lives of the other owners and the proceeds of the life insurance policy on the life of the deceased owner are received on a tax-free basis by the surviving owners as the designated beneficiaries. The proceeds are then used to purchase the interest of the deceased owner. One way to minimize the insurance costs to individual owners is to obtain a split-dollar policy, where the premium payments are shared by the business entity and its owners. Upon payment of the proceeds, the business entity is reimbursed for the premiums it paid and the balance of the proceeds is used to fund the buyout.
Under a redemption agreement, the business entity is obligated to purchase the interest of the deceased owner. The entity purchases life insurance policies on each owner and the proceeds of the life insurance policy on the life of the deceased owner are received by the business entity as the designated beneficiary and then used to purchase the interest of the deceased owner.
Sinking Fund in the Business Entity.
The business entity can establish a sinking fund to be used to fund a projected buyout. Possible problems with this funding method are the occurrence of a premature triggering event and the possibility of an accumulated earnings tax dispute.
Borrowed Funds.
The business entity or remaining owners can fund a buyout with borrowed funds. However, such funding usually requires a personal guaranty by the remaining owners and involves the ability to obtain such a loan, loan costs, interest, et cetera.
Installment Payments.
In situations such as retirement or outside sales where funding mechanisms such as insurance are not available, the Buy-Sell Agreement will often provide for a down payment with installment payments over a number of years at a defined rate of interest.
Estate Tax A Buy-Sell Agreement can be utilized to lower estate taxes, especially in family businesses with heirs who are active in the business. A reasonable but conservative valuation method will establish the value of the business interest of the deceased business owner for estate tax purposes and lessen the chance of an estate tax audit. This value will be lower than the fair market value of the business interest at the time of death. The business is then passed on to the heirs without excessive estate taxes resulting from a high valuation. However, any value selected is subject to IRS scrutiny and possible challenge, and therefore the valuation method should be reasonable and have a rational underlying basis.
Summary A Buy-Sell Agreement is an essential business and estate planning tool for any closely held business entity and its owners. It establishes a valuation method and payment terms for certain events prior to their occurrence, thereby eliminating disputes and possible litigation when the event actually occurs. A Buy-Sell Agreement is a contract between the business owners that dictates who can buy the interest of the departing owner, establishes a purchase price through a defined valuation method, and provides the terms of payment, while also setting the value of the business interest for estate tax purposes.
