When you own a company, by yourself or together
with one or more partners, you pour heart and
soul into making it a success. Indeed, the process
of bringing a business into existence and then
nurturing it and building upon its success is
so engrossing and exhilarating that it’s easy
to lose sight of one sobering fact: You and
each of your co-owners (partners or shareholders)
one day will take leave of the company. It may
be by retirement, disability or death. Someone
may feel the need to move on. A partner may
be tempted by a third party’s offer for his
or her share of the enterprise.
Potentially, any of these situations can throw
a going business and/or the family of a deceased
owner into chaos. A family may be forced to
sell its share to cover taxes on the estate—if
it can find a willing buyer. Remaining partners
may not be able to get along with an interloper
who comes into the business through purchase
or inheritance. In an S corporation, the new
shareholder may not be of a class eligible to
hold such shares, thus forcing a reorganization.
A versatile tool
Buy-sell agreements provide a powerful business
succession tool that owners of small-to-medium-sized
companies can use to address any or all of these
eventualities. A form of shareholder agreement,
the buy-sell agreement is a contract spelling
out what will happen to the equity of a departing
shareholder when a “triggering” event occurs.
Buy-sell agreements will generally fall into
one of two categories:
- In a cross-purchase agreement, the shares
or interest of the departing partner are to
be bought by the surviving or remaining partners.
In a sole proprietorship, the designated purchaser
would be the owner’s chosen successor, whether
a family member involved in the business or
a key employee vital to its continuation.
- In a stock redemption plan, the equity or
shares are bought and retired by the corporation
or partnership, thereby increasing the remaining
shareholders’ share of the company’s equity.
The choice between these options will depend
on the company’s structure and the resources
available to fund the purchase. Agreements may
set varying terms for different triggering events.
For example, a lower price may be paid to a
partner leaving to set up a competing business.
Purchases might be mandatory upon the death
or disability of a partner, whereas voluntary
or forced withdrawals might give the business
only “the right of first refusal”—to match a
first legitimate outside offer, if it so chooses.
Funding choices
Often life insurance and, less frequently, disability
insurance are used to fund buy-sell agreements.
The contractual buyer purchases a policy on
the prospective seller’s life. The proceeds
are earmarked to purchase the business interest
from the heirs of the deceased owner, and the
cash value is available to fund purchases in
other situations. In cross-purchase agreements
each owner needs to have a policy on the life
of each of the other owners.
Because this process can be quite cumbersome
when there are multiple owners, a stock redemption
plan may be more workable. In that case, the
business owns and funds a single policy on each
owner’s life. Life insurance cash value is carried
as an asset on the corporate balance sheet and
will not be considered an excess accumulation
of earnings if it does not exceed the reasonable
needs of the business.
The hard part
Placing a value on a closely held business can
be a challenge. Placing a future value is nigh
on impossible. For this reason it may be best
to specify a reasonable method that will be
used to determine the price to be paid, or to
recalculate the price periodically.
Methods that may be appropriate, depending on
the nature of the business, can be to: capitalize
average earnings over a period of years; calculate
the loan amount that the company’s cash flow
will support; total the tangible assets on the
balance sheet; place a value on the business’
intangible assets (often its customer base);
or simply apply an industry rule of thumb. Any
method specified in a buy-sell arrangement that
represents a true arm’s length valuation will
be binding on the IRS for estate tax purposes.
The payoff
A well-structured buy-sell agreement can provide
a panoply of benefits:
- ensuring an orderly transfer of business
interests, preventing forced liquidation;
- protecting the heirs of minority owners
who otherwise might end up with a holding
of restricted, non-dividend-paying stock;
- preventing a sale to outsiders or inheritance
by someone not active in the business;
- persuading a key employee to remain in
the business;
- establishing the value of a deceased owner’s
shares for estate tax purposes.
If you run a business, we’re always ready to
work with you and your advisers to develop buy-sell
agreements and all other financial services
available to help your enterprise thrive.
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