Most business owners are familiar with buy-sell agreements. The way they work is relatively simple. What’s not so simple is tailoring an agreement to meet the specific needs of a business. Too often, business owners use “canned” buy-sell agreements that don’t consider the individual circumstances of the owners involved. To help you anticipate potential disputes, consider these six steps when drafting a buy-sell agreement.
Plan Your Funding
Businesses frequently fail to properly fund a buy-sell agreement. Few owners will have readily available cash to buy out the remaining shares of the business, and banks may be reluctant to lend, especially if the business is young. The most common solution, though not the only one, is to take out a life insurance policy on each partner or shareholder equal to the value of that partner’s interest in the business.
Revalue the Purchase Price Regularly
Determining the purchase price at the beginning, when everyone agrees, is relatively easy. But situations change, and business values change with them. Having the business appraised on a regular basis goes a long way in alleviating disputes and carries more weight with the Internal Revenue Service. A yearly appraisal, however, can be too costly for many businesses. One solution is to have an appraisal every five years. In this situation, the appraiser may base the value in intervening years on a formula specifically generated for the company, which has a five-year life. At the next full appraisal, the appraiser revises both base value and formula to reflect current conditions. While not as accurate as a full appraisal every year, this strategy is more effective than simply relying on the original valuation with no updates.
Consider Majority vs. Minority Owners
A majority owner may want family members to take over the business to avoid giving minority owners the opportunity to buy out his or her stock.
Determine All Possible Triggers
Nearly all buy-sell agreements allow the death or retirement of an owner to trigger a buy-sell option. But be sure to consider some other events that are often overlooked: disability, divorce, firing, personal bankruptcy or criminal prosecution.
Decide Whether All Situations Should Be Valued the Same
Should the price be lower in certain situations that trigger a buy-sell agreement than in others? For instance, should an owner who leaves in a way that is detrimental to the business receive less for his or her shares?
Allow for the Right of First Refusal
A common provision in buy-sell agreements is the right of first refusal, which stipulates that the departing owner cannot sell his or her shares without first offering them to the remaining owners.
Conclusion: A Buy-Sell Agreement Is Important!
Business owners who take the time now to carefully consider all of the aspects and implications of their buy-sell agreements will face fewer problems when shares change hands. If, on the other hand, you have been careless about your buy-sell agreement, at that point, it will be too late. We help many closely-held business owners with tax-planning design of valuation formulas and other aspects of equity interest transfers intended to provide a smooth succession, either voluntary or forced, due to health or other events. If you, a relative or a colleague has an interest in a closely-held business, you might want to discuss its eventual disposition with your team of advisors or to provide guidance in setting up a buy-sell agreement.
A good time to start the process? Call today to set up a meeting with your accountant/advisor/appraiser and your attorney. If you don’t have an attorney seasoned in such matters, not to worry – we’d be happy to recommend one or more credible lawyers we feel has the technical prowess and experience to “join the team”.
As mentioned in previous newsletters, distributed at a seminar sponsored by the New York State Bar Association as well as the New Jersey Bar Association entitled “Shareholder Agreements – What You Need to Know”, was Abo Cipolla Financial Forensics’ 122-point checklist. The checklist, compiled to assist in drafting a well thought out buy-sell agreement, is available to clients and colleagues upon request at www.aboandcompany.com or by calling us at 856-222-4723.
Abo and Company, LLC and its affiliate, Abo Cipolla Financial Forensics, LLC, Certified Public Accountants – Litigation and Forensic Accountants are members of XPX-Philadelphia. The above article was retrieved from the “E-mail alerts” disseminated to clients and friends of the firm. With offices in Mount Laurel, Morrisville, PA and Franklin Lakes, NJ, tips like the above can also be accessed by going to the firm's website at www.aboandcompany.com or by calling 856-222-4723.