Protect Your Business with a Buy-Sell Agreement
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.
When & How Should The Buy-Sell Agreement Be Negotiated?
In order to be most effective, buy-sell agreements should be negotiated by partners before the document is needed and when all partners are optimally functioning together as a team in running the business, preferably at the beginning of the business. This is the perfect time, while all partners are at the table, to discuss options for exiting partners and onboarding new partners before special situations develop. The objective is to establish the definition of fair market value that meets IRS guidelines and is supported by the necessary funding to quickly transfer ownership without disputes. Moreover, it should identify the price through a detailed valuation formula or an appraisal process that should be calculated at the end of each year specifying the agreed-upon value of the company. It is critical that these plans are made now with exiting partners in sound mind rather than dealing in a crisis mode with unexpected third parties who may not understand the business.
In crises without a plan, the remaining partners could be dealing directly with spouses and children of the decedent who have limited knowledge of the business and unreasonable expectations on valuation and payment terms. Most likely, they would be inclined to appraise the company at an abnormally high value, and they would expect to receive full payment now, sometimes forcing liquidation, the least attractive method of transitioning a business. Moreover, they might be inclined to reduce their risk by removing their names from personal guarantees for lines-of-credit and leases, and this action could result in significant legal exposure and serious cash flow challenges in running the business. Worst case, they may intentionally delay transition thinking they could run the company more effectively. These risks and the cost of mitigating them increase in magnitude as the timing of the transition is prolonged.
From the family’s perspective, the remaining partners may not offer a fair price for their business interest, and worse yet, may delay payments into the future and perhaps forever.
Again shareholder and family disputes can become overwhelming and very personal and can delay final resolution for years resulting in astronomical legal fees. Moreover, the lack of unity places extreme pressure on those responsible for running the company who may not have the necessary controlling interest to run the company without full agreement with family members. The lack of a controlling interest could paralyze the company, and put it out of business negatively impacting owners, employees, customers, and vendors.
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.
These are situations that are not normally top-of-mind when the business is first started and all partners are getting along, and are in good health. But eventually one of these events will trigger a change in ownership transition. Everyone is best suited when owners prepare for it now before the need arises at a later date. Preparedness is especially important when there is an unexpected loss of a partner through an illness, disability, or death.
Additionally, partnerships need protection over a partner selling his/her shares to an unwanted partner. Partnerships are usually protected by first right of refusal for purchasing the shares of stock from the exiting partner. Again, this is important language that needs to be included in an effective buy-sell agreement.
Transition Risks Can Be Substantial and Not Readily Apparent
Although buy-sell agreements makes perfect sense, it is typically a document that is neglected by partners because the need is not immediate and the risks are not understood just how devastating they can be. Consequently, many companies don’t have one, and the ones that do, most likely have not spent the necessary time to understand it and apply it with real financial numbers. In fact, having a poorly written document that is not fully understood by business owners may cause more settlement issues than it resolves.
Many times, this important document is delegated to general counsel who may lack the business experience and legal expertise to secure the company, owners, and the immediate family. What could result is a composite of boilerplate legal language copied from other legal agreements without the full understanding of what is important, what could go wrong, and the wishes of ownership. Likewise, since it is not an immediate concern at the time it is prepared, there is a tendency to place the document on the shelf with a false sense of security. It is understood by most business owners, as a checklist item that is needed as part of good corporate governance, and once you have it, you are protected. There is nothing further from the truth.
There are four key questions of risks that need to be considered in an effective buy-sell agreement that could place undue hardships on the Company, its partners, and the immediate family. As you can readily see, the challenges of moving the company forward in this settlement process can be pervasive, overwhelming and emotional.
- 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? You might be expected to run the company without the support of a key partner, without the necessary ownership to make decisions, and with the added pressure of working with outsiders. Basic business decisions may no longer be easy to make. Even worse, the decedent’s family may expect you to accept all of the risk of operating the company, negatively impacting long-term lease agreements, banking lines-of-credit, and other long-term commitments requiring personal guarantees. Consequently, your long-term outside partners may become nervous and concerned about potential legal disputes between ownership. All of these risks can seriously impact the going concern status of the business.
- 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? The simple truth is that valuations between appraisers can vary significantly and could result in lengthy legal disputes and arbitrations. This process is fraught with pitfalls caused by differences of opinion on what the company is worth. It could take years to resolve these differences, leading to dysfunctional and strained relationships and substantial legal and valuation expense. In the meantime, the benefits of a profitable business could inc the family to pursue the dispute for as long as possible, thereby increasing the settlement price beyond the intended date of transfer. A typical valuation process used in many buy-sell agreements recommending agreement of more than one valuation expert can be expensive, time consuming, and ineffective in reaching a decision.
- How do you pay off the exiting partner without a supplemental insurance policy? Sellers most likely prefer their money upfront, and buyers may not have liquid funds available to satisfy this demand. This unmet need will involve a further negotiation of payment terms regarding opposite desires of interest rates, payback periods, and loan security. Reasonable demands are not guaranteed during these negotiations, most likely delaying settlement. For complete fairness to all parties, the buy-sell agreement should identify a payment method of a complete cash settlement in order to complete the transition and to resolve ongoing payment disputes.
- How does the family ensure that it is receiving fair market value and payment to fund their retirement needs? The available cash may not be available to pay the family their expected value. Furthermore, the immediate family could be saddled with additional risk of personal guarantees for bank loans and long-term leases. Finally, there are no guarantees that a successful business with continue after the loss of a key business partner.
Checklist for Buy-Sell Agreements
Developing an effective buy-sell agreement is of paramount importance for securing the future of your business and protecting owners and their families. Rather than starting with a formal 10 page legal document prepared independently by your attorney, start the process by calling a meeting with your partners and begin discussing possible concerns about future ownership transfers of the business, encouraging everyone’s viewpoints as candidly as possible. Hire a financial advisor who has experience in such transitions to lead these discussions making sure important issues are addressed. Once you capture this collective thinking, you can incorporate it into a legal document working closely with a carefully selected attorney who has specific experience in preparing such documents, understands transition risks, and understands your business risks.
After it is written as you want it, review it with your service providers’ soliciting their input. Also, make sure that you and your partners fully understand the document and don’t leave any uncertain language to interpretation. Reviewing and updating this document annually using your latest numbers offers transparency and confirmation of the process as well as quantifies the incremental value driven by your business.
Here is a checklist of other important issues you should consider in developing, reviewing, and updating your buy-sell agreement:
- Engage a financial advisor with business valuation, business transition, corporate governess, and CFO experience. The financial advisor should lead the annual review process and make sure that sensitive issues are addressed with all partners in this process. One of the important assignments will be to identify a method of valuing the company that is meets IRS fair market value requirements. Once developed and agreed upon, this method needs to be fully understood by all partners and calculated annually to confirm the agreed upon valuation of the company. It should be part of the annual ritual of closing the books and preparing the tax returns, and should be included as part of corporate minutes. Be smart, prepared and do not leave anything to interpretation. Use the annual company valuation to help you manage the annual results of the company. It is the perfect mechanism for evaluating and rewarding management for creating owner value.
- Engage an attorney that has recent experience in preparing buy-sell agreements and/or litigating business transitions. This is not a document that should be delegated to junior members with little business experience. Guard against using standard boiler plate language that you don’t understand. A knowledgeable attorney will add incredible value to this document.
- 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. Without this active and ongoing review, this document could be giving partners a false sense of security. Without your active involvement and understanding, the risks are overwhelming and under estimated. Remember that misleading or irrelevant legal language and inappropriate legal solutions could cause significant issues when it is time to implement. As a case in point, avoid using one common practice of suggesting an arbitration process using valuation experts representing both parties, and a third to resolve disagreements. This might sound fair and reasonable now, but trying to implement it without major differences of opinion and significant legal and expert cost is next to impossible.
This comprehensive communication process ensures full understanding by ownership which is the most important aspect of implementing it when needed. Ownership controls the process rather than relying on the expertise of outside service providers. Small misconceptions and differences could become major obstacles in implementing it quickly and fairly as intend by the original partners.
- The agreement should specify by partner, if applicable, the funding sources to facilitate the transfer of ownership to the partner leaving from the partners remaining. Proposed payment plans and interest rates should be included in this planning, but remember a cash settlement is the preferred option by the immediate family.
- The agreement should make sure that the remaining owners have the control necessary to run the company until the ownership transition is completed.
- Service providers including CPAs, attorneys, personal advisors, and insurance brokers should be briefed on the agreement and have copies for their files.
- Once a triggering event transpires, the document needs to be implemented as soon as practically possible. Elapsing time becomes an impediment of getting the deal done, and the longer the delay, the greater the risk of having major issues. There should be a stated time frame for completing the transition quickly.
- Protect your partners by including first refusal language in the document so that all ownership changes go through a vetted legal process. It is important for partners to have the ability to purchase available shares and manage the admittance of new partners.
- In summary, the agreement needs to be bullet proof, and fully understood by all parties so that it can be practically implemented quickly when needed. Likewise, each partner needs to understand it fluently and include it in their estate planning process and with full disclosure to key family members, key service providers, and the executors of estate.
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.
Fortunately, there is a simple solution. This risk can be significantly mitigated with a well thought-out, fully understood, and annually reviewed buy-sell agreement. In simple terms, it allows a business to transition ownership to remaining partners quickly at a fair price and reasonable payment terms, preferably a cash settlement. Moreover, key-man life insurance can be secured now to fully fund this transfer of ownership without disputes and out of pocket cost to all remaining parties.
Due to the importance of this document, ownership cannot delegate its development solely to the discretion of one’s family attorney who most likely will not have the necessary experience and legal knowledge to make it bullet proof. Instead it is critical to hire a financial advisor experienced in transitions and valuations to lead the partnership group in preparing the important requirements of the buy-sell agreement that reduce transition risk. Along with this advisor, it is absolutely critical that partners take an active role in developing and updating this agreement among themselves and review it at the end of each year as part of the annual close and preparing it along with the annual tax returns. It should be reviewed and updated each and every year with new copies filed with the corporate minutes.
There is nothing more important to the continuity of the business and the security of all parties involved than an effective buy-sell agreement.
This story is Partner Content.