Avoid succession obstacles with a buy-sell agreement
June 14, 2023
Recently, the critically acclaimed television show “Succession” aired its final episode, depicting the chaos and uncertainty that can take place if a long-time business owner fails to establish a clearly written and communicated succession plan.
To some, it may be obvious that a buy-sell agreement is needed, but many owners don’t see this need because they get along well with their partners and can’t imagine any issues arising. They may also perceive other pressing business matters as more significant, diverting their attention away from the need for a buy-sell agreement. However, it is crucial to acknowledge that unexpected circumstances can arise, such as changes in personal circumstances or differences in long-term business objectives, making a buy-sell agreement an essential precautionary measure for the stability and continuity of the business.
While there are many aspects to succession planning, one way to put some clear steps in writing — particularly if your company has multiple owners — is to draft a buy-sell agreement.
A “buy-sell,” as it’s often called for short, is essentially a contract that lays out the terms and conditions under which the owners of a business, or the business itself, can buy out an owner’s interest if a “triggering event” occurs. Such events typically include an owner dying, becoming disabled, getting divorced or deciding to leave the company.
If an owner dies, for example, a buy-sell can help prevent conflicts — and even litigation — between surviving owners and a deceased owner’s heirs. In addition, it helps ensure that surviving owners don’t become unwitting co-owners with a deceased owner’s spouse who may have little knowledge of the business or interest in participating in it.
A buy-sell also spells out how ownership interests are valued. For instance, the agreement may set a predetermined share price or include a formula for valuing the company that’s used upon a triggering event, such as an owner’s death or disability. Or it may call for the remaining owners to engage a business valuation specialist to estimate fair market value.
By facilitating the orderly transition of a deceased, disabled or otherwise departing owner’s interest, a buy-sell helps ensure a smooth transfer of control to the remaining owners or an outside buyer.
This minimizes uncertainty for all parties involved. Remaining owners can rest assured that they’ll retain ownership control without outside interference. The departing owner, or in some cases that person’s spouse and heirs, know they’ll be fairly compensated for the ownership interest in question.
Funding the agreement
There are several ways to fund a buy-sell. For example, remaining owners can simply borrow money to purchase ownership shares.
However, there are potential complications with both options. That’s why many companies turn to life insurance and disability buyout insurance as a funding mechanism. Upon a triggering event, such a policy will provide cash that can be used to buy the deceased owner’s interest. There are two main types of buy-sells funded by life insurance:
- Cross-purchase agreements. Here, each owner buys life insurance on the others. The proceeds are used to purchase the departing owner’s interest.
- Entity-purchase agreements. In this case, the business buys life insurance policies on each owner. Policy proceeds are then used to purchase an owner’s interest following a triggering event. With fewer ownership interests outstanding, the remaining owners effectively own a higher percentage of the company.
A cross-purchase agreement tends to work better for businesses with only two or three owners. Conversely, an entity-purchase agreement is often a good choice when there are more than three owners because of the cost and complexity of owners having to buy so many different life insurance policies.
From an estate planning perspective
Buy-sell agreements can provide several important benefits from an estate planning perspective. From keeping ownership and control within a family or other close-knit group to creating a market for otherwise unmarketable interests and providing liquidity to pay estate taxes and other expenses. In some cases, a buy-sell agreement can even establish the value of an ownership interest for estate tax purposes.
These agreements can provide for the orderly disposition of each owner’s interest after a “triggering event,” such as death, disability, divorce or withdrawal from the business. This is accomplished by permitting or requiring the company or the remaining owners to purchase the departing owner’s interest. Often, life insurance is used to fund the buyout.
However, because circumstances change, it’s important to review your buy-sell agreement periodically to ensure that it continues to meet your needs. The start of a new year is a good time to do this.
Focus on the valuation provision
It’s particularly critical to revisit the agreement’s valuation provision — the mechanism for setting the purchase price for an owner’s interest — to be sure that it reflects the current value of the business.
As you review your agreement, pay close attention to the valuation provision. Generally, a valuation provision follows one of these approaches when a triggering event occurs:
- Formulas, such as book value or a multiple of earnings or revenues as of a specified date,
- Negotiated price, or
- Independent appraisal by one or more business valuation experts.
Independent appraisals almost always produce the most accurate valuations. Formulas tend to become less reliable over time as circumstances change and may lead to over- or underpayments if earnings have fluctuated substantially since the valuation date.
A negotiated price can be a good approach in theory, but expecting owners to reach an agreement under stressful, potentially adversarial conditions is asking a lot. One potential solution is to use a negotiated price but provide for an independent appraisal in the event the parties fail to agree on a price within a specified period.
Getting expert guidance
Creating, administering, and executing a buy-sell agreement calls for expert assistance. Our business growth and transition team can help you identify, gather and organize the relevant financial information to ensure a clear path forward. Reach out to us today to get started.