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June 2004 Avoid perils of outdated buy-sell agreements Changes in your business and personal situation may have already rendered your buy-sell agreement obsolete When "Blake" and his three co-owners started their company 20 years ago, they executed a buy-sell agreement that they thought would apply to all issues related to the death of an owner, an ownership break-up and so on. When one of the owners passed away and Blake dusted off their buy-sell agreement, he discovered that it provided only a “right of first refusal,” i.e., it essentially prohibited the heirs of the deceased co-owner from selling to outsiders. However, it was of no help in answering some very important questions, such as:
Now that reality had set in and the heirs were asking questions, Blake was dismayed by the lack of answers in the buy-sell document. It is not easy for business owners, in advance, to sort out the tough questions that need to be addressed in a good buy-sell agreement. However, the beauty of dealing with those issues in advance is that none of the co-owners knows whether they will ultimately become a buyer or a seller of a fractional interest in the business. Following are some key points to consider when you meet with your professional advisors to review your buy-sell agreement. Triggering events. Most buy-sell documents will come into play upon the death or disability of an owner and, perhaps, at a specified retirement age. Other possible triggering events include loss of an owner’s professional license, conviction of a crime, or bankruptcy (to the extent creditors may gain control of an owner’s interest). Also, addressing a voluntary early departure, perhaps due to owner disagreement, can be particularly important. Mandatory or optional buy-out. Most buy-sell documents provide a mandatory buy-out of a departed owner’s interest. That assures the minority owner or heirs that a market will exist for their business interest, and it assures the remaining business owners that they will not be saddled with uninvolved co-owners. In some limited cases, where ownership is entirely within a family, there may be an intent to retain the ownership within the family of the departed owner, in which case the arrangements are optional. Form of purchase. In general, buy-sell agreements are drafted in two forms: entity buy-outs or cross-purchase arrangements. An entity buy-out has the business itself as the party obligated to purchase the share of the deceased or departed owner, while a cross-purchase arrangement obligates the remaining co-owners individually to purchase the interest of the departing owner. In some cases, hybrid arrangements occur. For example, the remaining individual owners may have the first option to purchase the interest of the departed holder, but if they decline to do so (perhaps for cash flow reasons), the business becomes obligated to complete the acquisition. Flexibility in the “form” of the buy-out can be important, particularly for income tax reasons. Establishing one form of purchase may make sense at the time of drafting, but years later, when an event triggers the buy-out, the entity may have evolved into a different tax status, or tax brackets and tax rules may dictate that a different approach is better. Establishing a value. Business valuation is typically a crucial element of the terms of a buy-sell agreement. Some agreements will attempt to set a price annually, with each owner signing off on the agreed annual valuation. While that assures that a current and realistic business value is used, it is easy to overlook this annual price setting, and, before long, an outdated figure may apply. Alternatively, many agreements either mandate an independent valuation or attempt to define a formula approach to business valuation. Most formulas will start with book value and make adjustments for the appraised value of specified hard assets – e.g., real estate, equipment and fixtures – and, perhaps, goodwill. Other formulas will set the price to multiples of earnings or income capitalization calculations. One of the drawbacks of the formula approach is that what seems to apply best at one point in time may be entirely inadequate or inapplicable when the time to apply the formula occurs. For that and other reasons, many buy-sell agreements require an independent business valuation. Funding and terms. In many cases, the buy-sell agreement is funded with insurance to assure that the business is able to make payment to the heirs of a deceased owner. The business can purchase life insurance and disability insurance to cover such events. But what about the retirement of an owner, or an early departure for other reasons? In this case, terms of payment can be established by the agreement. For example, the document may require the departing owner to accept payment over ten years, at some specified interest rate, to assure that the business is able to meet its obligation. Some buy-sell documents will provide extended terms or a reduced valuation if the owner departs voluntarily before normal retirement age. If one or more insurance policies are in place to support a buy-sell agreement, it is worthwhile to review the details with a knowledgeable professional. Are the policy beneficiary designations correct? Has the death benefit coverage kept pace with the value of the business? Ounce of prevention. Buy-sell agreements can be invaluable in eliminating disputes and solving the tough valuation questions after a triggering event has occurred. If you are a business owner, having your buy-sell agreement and the related insurance contracts reviewed by a qualified professional in order to assure that all the bases are covered can be an invaluable “ounce of prevention.” Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |