Many of our clients are business owners. Although these businesses tend to be successful, we have found that many of the owners do not have clearly defined succession plans. This month, we will look at one of the best ways to outline a succession plan, especially when partners or family members are involved in a business.
Sebastian and Kathryn met as project managers for a Fortune 500 company. After a couple of years of collaboration, they decided they could accomplish more and make more money in their own business. They’ve worked out most of the details about their individual roles, financial contributions, how they’re going to raise additional capital, and even who else they might invite to join their venture. Their attorney advised that they also give some thought to a “buy-sell agreement” – a term that was new to both of them.
When they learned that it was an agreement for the eventual disposition of their business, they decided they had plenty of time to worry about that later – maybe 10 or 20 years from now. Fortunately, their attorney was able to explain why a buy-sell agreement should be part of the start-up documents, and they saw the wisdom of making it a priority.
A Buy-Sell Agreement is a written agreement among the owners of a business in which each owner agrees that upon the occurrence of a specified event (death, disability, termination of employment, etc.), their shares shall be sold to the surviving owners at a specific price, and further, each owner commits to buy the shares of their departing co-owner upon the occurrence of a specified event.
There are several reasons a good buy-sell agreement is important to you:
- A valid buy-sell agreement will protect you and your family.
- If you retire or become disabled, your chosen successors will buy your interest at fair market value.
- If you die while owning the business, a buy-sell agreement can guarantee your heirs a buyer and a predetermined price.
- A buy-sell agreement negotiated between you and an unrelated successor provides a valuation that you can generally rely on for gift and estate tax purposes.
Buy-Sell Agreements can be funded (usually with life insurance) or unfunded (usually with promises to pay). Funding a Buy-Sell Agreement with life insurance is usually the most practical method – the heirs get cash and walk away, and the surviving owner gets the deceased owner’s shares immediately. Unfunded Buy-Sell Agreements are usually better than no agreement, but the odds of the heirs ever getting paid are relatively low. Quite often the earnings are not sufficient to pay off the heirs.
There are generally three different types of buy-sell agreements:
- Cross-Purchase Agreement: A cross-purchase agreement allows the remaining co-owners to purchase the interest of a departing owner. Each co-owner must have sufficient capital to make the purchase. For the death of an owner, each owner generally acquires a life insurance policy on the lives of each other owner, and the death benefits received are required to be used to purchase the deceased owner’s interest.
- Entity (or Redemption) Purchase Agreement: An entity purchase agreement requires the business to purchase the interest of a departing owner. After the purchase, the remaining owners would be the only owners of the entity. It is also common to fund the purchase with a life insurance policy purchased by the business.
- Hybrid Agreement: A hybrid agreement provides the remaining owners and the business itself to purchase the interest of a departing owner. With a hybrid agreement, it is possible to give the individual owners the right to acquire the interest, but not the obligation. If the owners decline, the business would be obligated to acquire the interest of the departing owner. Alternatively, the agreement may allow for both the remaining owners and the company to purchase the departing owner’s interest. Therefore the hybrid agreement has characteristics of both the cross-purchase and the entity-redemption agreement and is the most flexible.
The valuation section of a buy-sell agreement is very important because it defines how the value of the owner’s interest will be valued when there is a change in ownership. Changes will inevitably occur. Partners or shareholders of closely-held companies will decide to part voluntarily or an event such as death will trigger the buy-sell agreement. If this section of the agreement is skipped, it will lead to increased costs and time to determine the value of the interest at the time of the change.
The method of valuation must be clearly defined. A method should be selected that determines current fair market value at the time of the triggering event. Vague language for a formula that establishes a range of prices, rather than a firm price should be avoided. The reason is that two valuation professionals using vague language may calculate two very different values, either of which is within “the range.”
In a company with two or more major shareholders, a cross-purchase buy-sell agreement will generally be among the co-owners. The same is true in a professional practice with multiple principals or partners. If the buy-sell agreement is an entity-redemption agreement or a hybrid agreement, the agreement will be between the owners and the entity (company).
If a company has only one owner, it’s up to that owner to find a successor and enter into a buy-sell agreement. Sometimes the successor will come from the next generation of the family.
When there is no related heir apparent and no co-owners, finding a successor can be difficult. A key employee might be designated. Or the owner of a successful medium-sized company or professional practice might actually acquire a smaller firm headed by a younger individual, in the hope that the prime mover behind the acquired entity will someday take over the larger firm. In any event, a buy-sell agreement should be in place between the current owner and the designated successor.
Life insurance is frequently used to “fund” a buy-sell agreement. That is, the insurance proceeds provide the buyer with the necessary cash to carry out the agreement.
A buyout agreement may require surviving owners or successors to pay a lump sum or periodic installments when a triggering event occurs. The choice of payment will often vary, depending on the nature of the triggering event. Buyouts that require a lump sum payment are likely to be funded with life insurance or lump sum disability insurance, if it can be obtained.
Under an entity-redemption agreement, the company buys and is the beneficiary of an insurance policy on the life of each business owner. Each policy is for the amount needed to buy that owner’s interest. In a reciprocal cross-purchase agreement, each party buys and is the beneficiary of a policy on the life of each of the other owners for the amount that is their pro-rata share of the buyout price.
Assume a hypothetical $1 million business with two equal owners. With an entity-redemption buyout agreement the company will buy, and be the beneficiary of, a $500,000 policy on each owner’s life. In a cross-purchase plan, each owner will own and be the beneficiary of a $500,000 policy on the other owner’s life. Obviously, the cross-purchase plan becomes more complicated as the number of owners is increased.