Even if not everyone has a will, most people understand why they should. But knowing how a business will go on without an owner or a partner can be just as important.
Unfortunately, the numbers suggest that many business owners have neglected this important task. According to PwC’s 2015 survey of U.S. family businesses, 75 percent lack documented succession plans for some or all senior roles in the company. The 2016 edition of the same survey found that only 43 percent of family firms had any succession plan in place at all.
As with personal estate planning, business succession planning may involve a variety of tools and techniques depending on a business owner’s goals and circumstances. But the worst plan is having no plan at all.
One tool that serves many businesses well is a buy-sell agreement. Despite the name, this is not a mechanism for selling the entire business. It is a contract among a business’s owners, or between the owners and the entity itself, which sets out the rules for handling certain specific, future events – usually the departure, planned or unplanned, of one of the owners. The agreement governs how to divide the interest of proprietors, partners or shareholders in the event that they can no longer work due to disability, retirement, death or various other circumstances.
You may hear a buy-sell agreement called a buyout agreement, a buy and sell agreement, a business will or a business prenup. While it is most often used in partnerships, privately owned companies or closely held corporations, it can be useful even for sole proprietors if the owner intends for a key employee or family member to take over the business one day.
Business owners gain a variety of benefits from entering into a buy-sell agreement. First, it can establish in advance a fair value, or formula for valuing, a share of the business. If one of the owners wishes to leave and the remaining owner or owners wish to buy the departing individual’s share, they will have competing interests regarding valuation in the moment. If they agree in advance, it is less likely anyone will feel unfairly treated.
Business co-owners may also wish to ensure that no one sells their stake in the business to a third party who does not share the existing owners’ values or vision, or to someone who is an impractical partner. A typical buy-sell agreement gives the business, the owners or both a right of first refusal on certain proposed transfers of a stake in the enterprise. This means owners are more likely to keep control of the business, even if an individual with a large stake chooses to leave. Similarly, an agreement could stipulate that stakeholders in a closely held business must sell their shares back to the business when they exit.
Buy-sell agreements can also be useful in creating liquidity in the event of an owner’s departure, especially if it is unexpected. The agreement can ensure the withdrawing owner will have a market for his or her stake in the business that might not otherwise exist. A buy-sell agreement also often allows the surviving spouse or adult children of a deceased owner to liquidate their inherited interest if they are not inclined or lack the capacity to participate in the business.
These agreements protect the business, as well as the owners. Properly structured, a buy-sell agreement can shield business assets in the case of an owner’s personal bankruptcy. It can also mitigate otherwise significant tax consequences stemming from an owner’s unexpected departure; for example, S corporation buy-sell agreements often prohibit shareholders from transferring stock to a person or entity that is not a permissible S-corp shareholder in order to preserve the business’s existing structure.
As with personal estate planning, good business succession planning should not come as a surprise to the other parties involved. Co-owners will need to work together to create effective buy-sell agreements, but it is also important that other employees know that the business has a plan in place for an owner’s departure. Depending on the size of your organization, how much detail owners share may vary, but at a minimum, sharing that a plan is in place can give your employees peace of mind that the business will not collapse should an owner leave unexpectedly.
Elements Of A Good Agreement
Like a will or prenuptial agreement, each buy-sell agreement will reflect the particulars of the business in question. But the best ones all have one attribute in common: They are in place long before they are necessary.
Drafting a buy-sell agreement early in the life of a business allows partners or co-owners to discuss contingencies such as a stakeholder’s death, disability or retirement. It also creates a way to guard against possible but less certain future scenarios. These may include a serious argument between stakeholders, an owner’s divorce or bankruptcy, or a partner using a stake in the business as collateral and then defaulting on the loan. By the time any of these situations occur, emotions are likely to run high. Setting up a plan in advance can not only safeguard the business, but reduce stress on owners during potentially trying circumstances.
While it is never too early to develop a buy-sell agreement, it is also important to remember that it is not something to simply set and forget. As the business grows, owners will likely need to revisit the agreement, and potentially revise it to allow for expansion and changes in the operation. Revisiting succession plans every three to five years is a good idea, though as with personal estate planning, owners should also reassess any time the business experiences a major change, such as rapid growth, the addition or departure of an owner or major stakeholder, or substantial changes to the business model.
When business owners create – and subsequently revisit – a buy-sell agreement, they should gather a team of professionals to help. This team should include an experienced lawyer, an accountant, a tax expert and, potentially, a valuation professional. (Sometimes a single individual may fulfill more than one of these roles.) In some businesses, a buy-sell agreement may be the biggest component of succession planning; in others, it may be merely one part of an even larger plan. Depending on the circumstances, owners may also want to involve their personal estate planning professional or financial planner, too.
A valuation professional is a good addition to the team because valuing the business is both a crucial part of a good buy-sell agreement and a complicated undertaking. (A June 2015 Sentinel article, “How To Value A Professional Practice,” goes into more detail on this topic.) Some buy-sell agreements include a specific formula to determine the value of a stake in the business. Others simply include a clause specifying that a valuation expert will assess the business at the appropriate time when an owner leaves. Regardless of the formula or expert involved, the most important thing is for owners to agree on a valuation method in advance. This will reduce the potential for conflict when the time comes for an actual sale.
In addition to specifying a valuation method, a buy-sell agreement should include rules for who can buy and sell stakes in the business, and under what circumstances. For instance, the founder of a family business may want to ensure that the enterprise stays partly or completely in the hands of family members or in the future. In many cases, a purchaser will be the business’s other owners (called a “cross purchase”), the business itself (an “entity purchase”) or some combination of these two.
States with community property laws may require special consideration. If a business owner in a community property state divorces his or her spouse, the ex-spouse can seek partial ownership in the business during the divorce proceedings. If business owners wish to avoid this outcome, they can structure a buy-sell agreement that requires the ex-spouse to sell any stake in the business received this way back to the company; the ex can secure the equivalent monetary value, but will not retain any control of the business.
Another example of protection offered by a buy-sell agreement is that of an owner’s bankruptcy. A clause in the agreement that outlines the conditions that may trigger a sale can give the business the right to buy back the owner’s share outright. This may prevent bankruptcy trustees or creditors from taking control of the business in the course of bankruptcy proceedings.
Because issues like death, divorce or bankruptcy cannot always be anticipated, rules about funding are also an important part of a buy-sell agreement. Agreements should specify how the business will fund a buyout of a departing owner. Specificity allows the business to plan realistically for future obligations. Requiring an immediate lump-sum buyout can make buying back an interest challenging or even impossible for some businesses, so many agreements provide for a down payment followed by installments over a few years at a reasonable rate of interest.
In some businesses, especially partnerships, co-owners purchase life insurance policies on one another – or the business purchases policies insuring key personnel – in order to fund buyouts of an owner’s heirs in the case of his or her unexpected death. This technique can become expensive with larger numbers of shareholders, so it is not right for every business, but it is a common way to fund a buy-sell agreement among a few key individuals.
While buy-sell agreements primarily address nontax goals, owners should keep tax obligations in mind when creating them all the same. Funding concerns extend to how the business will pay the Internal Revenue Service, not only the seller.
Owners who are concerned about estate taxes, especially in a family business, can also use a well-constructed buy-sell agreement to help pass their stake to relatives using a realistic but conservative valuation formula. Valuation experts often discount the value of an interest in a business under certain circumstances (such as when the share represents a noncontrolling interest or when there is no readily available market to liquidate the share). Sometimes business owners will deliberately make a gift of a discounted share in order to minimize transfer tax. The Obama administration proposed regulations to curtail this practice, but the Trump administration jettisoned them last year, preserving the status quo.
The best buy-sell agreement is one that fits a particular business’s needs and long-term goals. With some professional help and foresight, business owners can avoid unpleasant surprises when, inevitably, one of their number goes his or her own way.