Business owners who have other partners, members, or shareholders need to consider what will happen to their ownership interest when certain events occur, such as retirement, death, divorce, or disability. A buy-sell agreement is a contract that formally documents the terms related to the transfer of ownership interests in a business. A buy-sell agreement ensures that the ownership transition meets the goals of owners and their families, and offers protection for the transfer of ownership interests in a business. However, many businesses do not have buy-sell agreements, or they are very outdated. Don’t get caught making these mistakes with your buy-sell agreement:
Mistake #1: Allowing the Plan to Become Outdated
When a buy-sell agreement is not updated regularly, the terms may not align with the owner’s current situation and future goals. If the value, or the method for determining the value of the business, are not updated regularly, the risk is high that an exiting owner will not receive the appropriate purchase price for his or her interest.
For example, if a Company has a fixed price buy-sell agreement, it is extremely important that this gets updated annually. If a Company is worth $6 million at the buy-sell agreement date and an owner is expected receive a buyout of 40% of this ($2.4 million) at retirement or death. What happens if the buy-sell agreement is not updated for a few years and Company is now worth $12 million? Unfortunately, this owner would receive well below the value that he should receive.
A second type of buy-sell agreement is a formula buy-sell agreement which are often based on a percentage of book value or a multiple of earnings. If not updated regularly, these plans can become outdated with what is happening in the Company as a percentage of book value or a multiple of earnings may be very different from the amount that would be shown on a valuation report.
Valuation of closely held businesses is as much of an art as it is a science. The value of a company will vary depending on the reason for the valuation. Valuation for estate planning purposes is likely to be on the low end of the spectrum compared to a valuation when selling to a strategic buyer. Both fixed price and formula buy-sell agreements have their advantages and disadvantages, however both should be updated regularly.
Mistake # 2: Not Picking the Correct Buyout Triggers
The events that trigger the obligation to sell or buy an ownership are known as buyout triggers. Typically, these are retirement, death, divorce, and disability. A trigger normally prompts one of three rights – an option of a buying owner to buy out the selling owner’s interest, an option of the selling owner to force the buying owner to buy him/her out, or a mutual obligation on both the buying owner to buy and the selling owner to sell the ownership interest.
As viewpoints and goals of owners change throughout the years, it is important to have the correct buyout triggers so that the ownership structure continues as desired. All buy-sell agreements can be set up differently, therefore it is important to consider everyone’s goals. A trigger event may force an owner to buy out another, however that outcome may not be what was desired. In the absence of a workable buy-sell agreement, the remaining shareholders and the corporation may be placed in the unenviable position of negotiating under adverse circumstances with former friends, their families, or estates. Such negotiations are difficult and often lead to litigation.
Mistake #3: Agreement is Unfunded, or Funding Structured Improperly
Particularly during the start-up and growth stages, a closely held business is vulnerable to a shortage of capital should a buy out need to occur. Many times, a buy-sell agreement requires a buyout of ownership interests upon the triggering event, however no planning has been done regarding how to fund the buyout. Without proper funding, the surviving shareholders may be unable to meet commitments under the buy-sell agreement, and oftentimes rely on current cash flow or borrowing funds. The typical approach to funding is to purchase life and/or disability income insurance. However, many issues arise in determining adequate coverage and improper ownership and beneficiary designations.
Buy-sell agreements can be a valuable tool for closely held businesses and owners who want to protect their ownership interests. But if drafted improperly, or allowed to become out of date, these contracts can cause problems for both buying and selling parties. To ensure a satisfactory outcome, owners should work closely with their CPAs and a team of professionals such as an attorney, an insurance agent, and a business valuation analyst to prepare and update an appropriate buy-sell agreement.