Protect Your Business with a Buy-Sell Agreement
by Edward B. Lasak, CPA, MS
Partner Content, part of the “_______” Journey series.
With 35-years as a CFO, COO, Ed collaboratively consults with and empowers business owners by developing high-potential exit strategies, succession plans, and company valuations integrated with a comprehensive strategic vision.
Secure Your Future with a Functioning Buy-Sell Agreement
Riverside, Ca – If you operate a business with partners, in any capacity as a Limited Liability Corporation (LLC), an S Corporation, a C Corporation, or even with a basic partnership agreement, there is nothing more important to the continued success of your business and the security of your partners and family than a functioning, up-to-date buy-sell agreement. Moreover, it is just as important in family operated business where business owners are family members.
Unfortunately, many small businesses do not have a buy-sell agreement, or worse yet, they may think they have one, but are not quite sure how it would work when needed.
More specifically, the most prevalent and potentially devastating risk of unexpected transition is the lack of an agreed-upon business valuation coupled with the lack of funding to complete the transition. This unexpected risk can cripple a business due to internal quarreling, unreasonable expectations, lack of control, and unpreparedness.
These issues can create overwhelming legal disputes that could result in liquidating the company for pennies on the dollar, incurring large legal liabilities without successfully mitigating disputes, and destroying long-term relationships between partners and family members. It quickly creates an atmosphere of contention and mistrust leading to an “us versus them” atmosphere, and could result in costly lawsuits and legal expense. In the meantime, ownership is expected to run the company, many times without the necessary ownership control necessary for making important decisions to support the business.
What Is a Buy-Sell Agreement and Why Is It Necessary?
So what is a buy-sell agreement? It is a legally binding contract for the sale of stock or assets of a company to facilitate ownership transitions. Specifically, it governs the process that will take effect upon a future change in ownership, either to exit an existing partner out of the business, to admit a new partner into ownership, or to sell or liquidate all or part of a company. Sometimes it is needed during an emergency to facilitate the unexpected transition of ownership after the death or disability of a partner, and this is where the greatest risk resides to the business.
Changes in ownership require a legal settlement of equity in the business along with appropriate funding and payment terms to compensate a partner for his/her ownership in the business. Buy-sell agreements prescribe the legal process for transacting these changes in ownership quickly, and in accordance with predetermined and agreed-upon procedures and methods of valuation. It also identifies the funding mechanism for these transitions, whether through agreed-upon cash payments from ownership, key man life insurance policies, and/or a purchase of the stock from the company based upon future cash flows of the company, also known as an earn-out approach. As a general rule, transitions are best funded by key man life insurance policies, but unfortuneately many times these insurance policies lapse due to increasing cost and neglect, taking away this powerful funding option, when needed during a crises. Likewise, sometimes owners do no qualify for life insurance or the cost becomes prohibited so other funding options need to be identified.
Buy-sell agreements become even more important when one of the partners is impacted by disability or death. In these unexpected situations, a key member of the partnership is no longer available to participate and lead in the transition of ownership. Instead, partners and the immediate family must rely on a prescribed legal process in place to transfer ownership to the surviving partners and to provide payment to the immediate family for their financial interest in the business without disputes.
To further complicate the matter more, it is usually transacted at a time of great stress during the loss of a partner and loved one. If not transacted quickly in a predetermined manner, this untimely event could bring family members of the immediate family into the management of the business without the necessary knowledge, skills, and experience to facilitate the management process. As you can imagine, this risk may cause major friction in running the business that could paralyze the company and further delay the transition. On the other side of the coin, delays could negatively impact a fair settlement and the expected cash flows to the immediate family. In order to remedy these potential risks, buy-sell agreements should be executed and funded quickly.
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- When & How Should The Buy-Sell Agreement Be Negotiated?
- What Triggers a Buy-Sell Agreement?
There are several unforeseen events that could result in a change in ownership which would trigger the need for a buy-sell agreement. Here are just a few common events that could trigger a change in ownership.
- Resignation: one of the owners wants out of the business.
- Termination: there may be a need to remove a partner.
- Retirement: a partner may want out of the business to pursue other interests.
- Divorce: a partner may want out of the business after a divorce, and his/her spouse may want to become part of the partnership.
- Personal bankruptcy: A partner may legally need to cash out.
- Disability, death, or incapacity: a partner may no longer be able to continue on with the business.
- New partner: the partnership may want to admit a new partner perhaps with special skills, additional capital, or key business relationships for growing the company.
Transition Risks Can Be Substantial and Not Readily Apparent
- How do the remaining partners continue operating without the services of a key partner and perhaps with less than a controlling interest in the company with outside pressure exerted by the family?
- How do you value the partner’s ownership in the company without a clear cut valuation formula that meets IRS fair market value requirements and the expectations of the seller and buyer?
- How do you pay off the exiting partner without a supplemental insurance policy?
- How does the family ensure that it is receiving fair market value and payment to fund their retirement needs?
Checklist for Buy-Sell Agreements
- Engage a financial advisor with business valuation, business transition, corporate governess, and CFO experience. e.
- Engage an attorney that has recent experience in preparing buy-sell agreements and/or litigating business transitions.
- Once you have a buy-sell agreement, call an annual meeting with ownership to discuss it, understand it, enhance it and apply it to that year’s financial performance.
A major and somewhat hidden risk to any business partnership, in any legal form, is the lack of a highly functioning, well thought-out, fully understood, and annually reviewed buy-sell agreement. Furthermore, the greatest risk is triggered by the unexpected death, disability, or incapacitation of one of the business partners, where that partner is no longer able to participate in the business or to negotiate his/her final ownership settlement with other partners in the business. This final settlement is necessary to transfer ownership to the remaining partners and payment to the immediate family at fair market value allowing the business to continue operating as a going concern.
Without the benefit of a buy-sell agreement, especially during a stressful time of personal loss, remaining partners and family members will be required to actively negotiate a settlement without the leadership of the former business partner and family leader further complicated by the added pressures tax filing deadlines. At this time, with no agreed-upon legal agreement in place to rely upon, both sides will encounter the normal differences of objectives between buyers and sellers without a common understanding of the business making settlement difficult at best and time consuming to implement. In the meantime, the business may be paralyzed due to the remaining partners not having a controlling interest to run company, and settlement could take years to resolve. In some situations, liquidation of the company becomes the only viable alternative to satisfy all parties, and this option also negatively impacts employees, customers, and vendors, innocent bystanders to this process. Family and partnership relationships could be harmed for life.
There is nothing more important to the continuity of the business and the security of all parties involved than an effective buy-sell agreement.
Need a comprehensive plan? Contact Ed Lasak.
This story is Partner Content.