Buy-Sell Agreements

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What Is a Buy-Sell Agreement?


When a business owner dies, the disposition of his or her business interest can become a two-edged sword, creating problems for the business owner's heirs as well as the business itself. Critical questions must be answered:


        Who will purchase the business interest?


        What is a fair price?


        When will the sale be made?


        Where will the funds come from?



This "disposition dilemma" is easily resolved when a buy-sell agreement is established. This agreement provides that:



        someone (e.g., the business entity, the surviving owners, or a key employee) will purchase a deceased owner's interest at an agreed-upon price, and


        the deceased owner's estate is obligated to sell the interest at that price.



The Purpose of Buy-Sell Agreements



For illustrative purposes, imagine yourself in partnership with two associates.



The other two partners are Bob and Elaine. If Bob dies, his business interest passes on to his estate, and ultimately to his wife, Megan. Unfortunately, Megan knows nothing about the business. You and Elaine do not want to form a new partnership with Megan as a business partner, and you don't want Bob's interest sold to an outsider.



It should be added that Bob and Elaine face the same dilemma regarding your heirs.


Fortunately, if a buy-sell agreement is in place, none of these potential problems will arise.



All the owners know who will receive the deceased owner's business interest as well as how much will be paid for that interest.



A properly drafted buy-sell agreement:


        minimizes the possibility that the business might fall into the hands of outsiders


        minimizes the possibility that the parties involved will not be able to agree on a proper value for the business and puts everyone on equal footing while all the parties are alive


        minimizes the possibility that funds will be unavailable to make the purchase


        provides a deceased owner's estate with needed liquidity by converting an illiquid asset into cash.



It's easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner's heirs.



Entity Buy-Sell Agreements



Under an entity or stock redemption agreement, the business agrees to purchase a deceased owner's interest. To help fund the agreement, the business purchases life insurance on the life of each of the owners; the business owns the policies and is the beneficiary of each policy. The face amount of each policy approximates the purchase price for the insured's business interest. The purchase price is usually set in one of two ways:


        a definite fixed amount is stated in the agreement, or


        a formula is specified by which a definite price can be established.


When does a business need a buy-sell agreement?

Every co-owned business needs a buy-sell, or buyout, agreement the moment the business is formed or as soon after that as possible. Every day that value is added to the business without a plan for future transition, it increases its financial risk.


A buy-sell agreement is used for buying and selling businesses, right?

No. Despite the name, buy-sell agreements have little to do with buying and selling companies. Instead, they are binding contracts between co-owners that control when owners can sell their interest, who can buy an owner's interest, and what price will be paid. These agreements come into play when an owner retires, goes bankrupt, becomes disabled, gets divorced, or dies -- in other words, a buy-sell agreement is a sort of prenuptial agreement between business co-owners. Mainly these agreements guide buyouts between the owners themselves; that's why we like to call them buyout agreements.


If a co-owner of a business gets divorced, can the former spouse ask the divorce court for part ownership in the business?


In some states, yes, and the former spouse can succeed in getting it, too. In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), all earnings during marriage and all property acquired with those earnings are considered community property, owned equally by husband and wife. When property is divided during a divorce, each spouse can claim a right to all community property.


Even in non-community property states, a spouse could argue for a partial interest in the business, because marital property laws require property to be divided equitably during divorce.


To avoid this prospect, a good buyout or buy-sell agreement requires the former spouse of a divorced owner to sell any interest received in a divorce settlement back to the company or the other co-owners, according to a valuation method provided in the agreement.


Can a co-owner's personal bankruptcy affect the business?


In the worst case scenario, a bankruptcy trustee could liquidate the business (sell all of its assets) and take half to pay the bankrupt owner's debts. To prevent a business from getting tied up in bankruptcy court, the owners can sign a buy-sell or buyout agreement that requires a co-owner who faces bankruptcy to notify other co-owners before filing. Under the terms of this agreement, this becomes an automatic offer to sell the bankrupt owner's interest back to the other owners. The buyout money goes to the bankruptcy trustee and the business can proceed without difficulties.


What's the best way to value a company when an owner is being bought out?


You can hire a professional appraiser or use a valuation formula to come up with a price using financial statements from one or more years. But the problem is that valuing a business at the time of sale usually results in co-owners seizing on different valuation formulas, which can produce very different results. For that reason, it helps for the owners to agree on a way to value the company in advance in a buy-sell or buyout agreement. This gives owners the chance to discuss and vote on how a reasonable price for the company should be calculated. The fact that a sound method was agreed to beforehand can go a long way to reducing conflict when the time for a buyout comes.


What happens if a company needs to, but can't afford to, buy out one of its owners?


Requiring an immediate 100% lump-sum cash payout can prevent even the most successful company from buying back an owner's interest. That's why having flexible payment terms built into a buy-sell or buyout agreement, signed in advance, can help. For instance, a buyout agreement can provide for a down payment of 1/4 to 1/3 of the buyout price followed by installment payments for three to five years at a reasonable rate of interest.


Can a buy-sell agreement be used to avoid estate taxes?


Buy-sell, or buyout, agreements have been used successfully to lower estate taxes in intergenerational businesses -- businesses where at least one co-owner plans to leave the interest to heirs who will remain active in the business. This can help a family business owner pass the business on to children or other relatives without burdening them with unnecessary estate taxes caused by an aggressive value of the business. The key for estate planning is choosing a conservative price or valuation formula for the business in the buy-sell or buyout agreement. The result can be to legally set the value of the ownership interest at an amount considerably lower than its sales value at the time of death.