Article: A Second Look at Your Buy-Sell Agreement

A second look at your buy-sell agreement

The beauty of dealing with buy-sell issues upfront is that no one knows whether they will ultimately become the buyer or the seller

Ken knew that he and his co-owners had a buy-sell agreement. He recalled, when they formed the business over 15 years ago, the laborious discussions with the attorney about drafting language to assure that no one outside of the owner group could acquire an interest in the business.

But now one of his co-owners had unexpectedly died, and Ken dug out that old agreement. He found that all that was in place was a simple “right of first refusal.” The agreement served no purpose except to prohibit the deceased co-owner’s family from selling to outsiders.

Was the business required to buy out the heirs? If so, what price should they receive for their share of the business and under what terms? And who was to be the purchaser: the business itself or the individual owners?

It’s not easy for business owners, in advance, to sort out the tough questions that need to be addressed in any good buy-sell agreement. But the beauty of dealing with these issues upfront is that no one knows whether they will ultimately become the buyer or the seller. The unknown can be a great impetus in assuring that a buy-sell agreement protects both the cash flow interests of the business and the heirs’ right to a reasonable payment for the deceased’s share of the business.

Here is a checklist of key points to consider in reviewing your buy-sell agreement.

Triggering events. Most buy-sell documents come into play (a) upon the death or disability of an owner and (b) generally at a specified retirement age. Other triggering events are loss of an owner’s professional license, conviction of a crime, or bankruptcy (to the extent that creditors may gain control of an owner’s interest). Also, addressing the divorce of an owner can be particularly important where state law (such as Arizona’s) grants the non-owner spouse a community property interest in the business. An attorney conversant with marital dissolution law in the owners’ states of residency can help identify appropriate safeguards on this issue.
Mandatory or optional buy-out. Most buy-sell documents provide a mandatory buy-out of a departed owner’s interest. That assures, first, the minority owner or heirs that a market will exist for the business interest and, second, the remaining business owners that they will not be saddled with uninvolved or discontented co-owners. In some 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 agreement is drafted in optional form.
Form of purchase. In general, buy-sell agreements are drafted in two forms: entity buy-outs and cross-purchase arrangements. An entity buy-out has the business itself as the obligated party to purchase the share of the deceased or departed owner. In contrast, 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 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. This type of flexibility can be important, particularly because of income tax reasons. Establishing one particular form of purchase may make sense at the time of drafting, but ten 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.
Entity differences. In general, partnerships find little tax difference in an entity buy-out versus a cross-purchase. However, for a corporation (especially a C corporation) there are significant tax differences, particularly from the buying side, that merit careful evaluation.

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 not 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 tax issues, the owners’ goals, and other considerations. Which formula will you select?

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

Whatever approach is used, it is important for the co-owners to recognize that they must establish a fair payout to the heirs, while also assuring that the result is financially affordable for the buyers and the business.

Funding and terms. In many cases, the buy-sell agreement is funded with insurance, to assure that the business can afford the payments to the heirs of a deceased owner. Both life insurance and disability insurance can be acquired by the business to cover these events.

But how do owners prepare for the retirement of an owner or his or her early departure for other reasons?

If a whole life insurance policy with increasing cash values has been acquired, that asset may provide some binding capability, but in many cases it is necessary for terms of payment to 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 has the capability of meeting 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 as they should be?

Has the death benefit coverage kept pace with the value of the business?

Is the investment portion of the contract performing as expected?

Matters of ownership and beneficiary designation are particularly important when the more sophisticated forms of “split-dollar” agreements are used (i.e., the death benefit and investment portions of the life policy are split between an owner and the business).

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 to assure that all the bases are covered can be a very important “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.