The day you and your business partner launch your company–or some time soon after–you’ll need a buy-sell agreement. These agreements are not about buying and selling companies. Instead, they are binding contracts between co-owners that spell out when one person can sell his or her interest in the business and at what price. If you’re an owner or part-owner, your interest in the company might be your most valuable asset. Planning for that asset is vital; otherwise, you increase its financial risk.
Buy-sell agreements come into play should the business go bankrupt or when one partner decides to retire, becomes disabled, gets divorced, dies, fails to perform up to par, or simply loses interest and wants out.
A buy-sell agreement is sort of like a prenuptial agreement between business partners. The reality is that relationships in closely held businesses–just as with romantic relationships–break up. When they do, the emotional and financial stakes can be high.
Still, year after year, thousands of co-owners make the mistake of leaving key decisions to the courts, the IRS, or heirs. As a result, there’s no smooth transition of business assets and owners leave themselves, their partners and their heirs open to heartache, financial stress, excessive taxation, and possibly even dissolution.
Even if you are the sole owner of the business, you need a document in place to protect and prolong your legacy. Here’s what a buy-sell should include:
A successor or successors. If you have one or more co-owners, they probably will agree to buy your interest. In turn, you’ll agree to buy their interest, when required. If you’re the sole owner, you’ll have to find someone else to buy your business from you. That might be a relative, an employee, or the owner of another company. You might even hire someone who will be your designated successor.
The trigger events. Generally, your buy-sell will take effect at your death or disability. The agreement also may require a buy-out at your retirement, or if you leave the company for other reasons.
The buyout price. “Make sure there’s a current price on your interest or a mechanism for establishing a fair price at the time of the sale,” says Genevia Gee Fulbright, a CPA at Fulbright & Fulbright, CPA, PA in Durham, North Carolina. You’ll want an adequate price, if you or your heirs will be collecting. On the other hand, if you are obligated to buy an interest from a co-owner, you won’t want to overpay. Among unrelated co-owners, setting a price may be fairly simple. You can set a price by mutual agreement, then review that price every year or two, to update your buy-sell.
A formal valuation. Another approach is to set out a method for valuing your company, or your share of the company. The buy-sell agreement might say that a certain multiple of sales or net operating income will be used to value the seller’s interest. Setting a price between family members is a different matter. “Buy-sells between family
members are considered an area of possible abuse, so such agreements are scrutinized closely,” Fulbright says. The IRS feels such agreements tend to be low-balled to save gift and estate tax. Therefore, you will need a formal valuation, drafted by an unrelated and reputable appraiser, in order for an intrafamily buy-sell to pass IRS review.The funding. These days, a successful small business might be valued at several million dollars. A buyer probably will be hard-pressed to come up so much cash, even if he or she has an obligation under the buy-sell. “An appropriate life insurance policy can fund a buyout agreement,” says Lee Slavutin a principal at Stern Slavutin 2 Inc., a life insurance and estate planning firm in New York City. You might own a policy on the life of your business has a policy on Ann’s life. When one of you dies, the other will collect the insurance proceeds, which can be used to pay the agreed-upon price. Also, “Disability buy-out insurance may
be used to fund a buy-sell that’s triggered because an owner no longer can work,” Slavutin says. For retirement, a cash value life insurance policy might be tapped; alternatively, a retirement buyout may be funded from accumulated earnings or paid in installments from the company’s ongoing profits.The buyer. For buy-sells among co-owners, two approaches are possible. One is the “cross-purchase” agreement. One partner buys the business interest from the other, depending on who is the first co-owner to depart. The other option is a “redemption” agreement. So, when one shareholder dies, the company buys his or her shares. The other shareholder will then become the sole shareholder. Buy-sell agreements often give the remaining co-owner a right of first refusal. If this right is waived, the company will buy the shares that are up for sale. With this approach, the surviving co-owners can consider all the circumstances (such as cash needed and tax concerns), then choose between a cross-purchase and a redemption buyout.