In our last issue of this Newsletter, we discussed the problems that can arise if a business continuity (buy/sell) agreement designed for one event (usually the death of a shareholder) is called upon to manage the more likely event of a shareholder’s departure during his or her lifetime. Lifetime departures may occur due to the retirement, termination, divorce or bankruptcy of an owner.
While it is true that poor design or failure to update the agreement—especially in tough economic times—can create significant problems, does that mean you and your co-owners shouldn’t have one in place? In a word, NO! The business continuity agreement may be one of the most important documents that you, as a co-owner of a closely held business, will ever sign.
For an idea of why, consider the case of Acme, a fictional company.
George Acme’s son-in-law, Tom Gardner, had worked for George for over 20 years. Tom had gradually assumed operational management and was the acting CEO. In recognition of Tom’s contribution, George had sold Tom—mostly at a low value—25 percent of the company.
Everyone expected that Tom would one day own Acme, Inc. But before that day arrived, George died and Tom’s sister-in-law became the executor of George’s estate. She decided to sell George’s share of the company—at its full fair market value and for cash—either to Tom or to the highest bidder. At the time, she did not understand that no third party would acquire a majority position in a company co-owned and run by a disgruntled CEO.
Had Tom and George created a business continuity agreement that reflected their wishes about value, control and successor ownership, the business would have transferred at a fair price to the benefit of all concerned. Because they had not done so, Acme was unlikely to continue at all.
As mentioned earlier, a business continuity agreement can control the transfer of ownership in a business when a variety of events occur including: an owner’s death, permanent and total disability, termination of employment, retirement, bankruptcy, divorce, and a business dispute among the owners.
The buy/sell agreement can further require that the business or the remaining owners to purchase the departing owner’s stock; or it may give an option to the business or the remaining owners to buy that ownership interest.
Lastly, it may give the departing owner the option to require the company to buy his or her ownership interest.
The agreement should establish the value of the stock, set the terms and conditions of the buyout, and give additional protection to all owners. In short, the business continuity agreement tells owners to whom they can sell, at what price and terms, and under what restrictions they can sell stock.
Advantages of a Buy/Sell Agreement.
The disadvantages of a buy/sell agreement are few if the document is well drafted and is kept updated for changes in ownership, value and other circumstances. (See Issue175.) With that in mind, the major advantages of a buy/sell agreement are:
1. Ownership in the business can be transferred only in accordance with the agreement. This benefits both the owner wishing to transfer stock and the other owner(s) wanting to acquire stock. In the first instance, the buy/sell agreement can provide a selling shareholder, or his/her estate, with a purchaser for fair value and upon terms and conditions that are mutually acceptable. For remaining owners (such as Tom), the agreement provides that any transfers of ownership must be made, or at least offered, to them. This eliminates the threat that an outside party or a co-owner’s spouse or children will become owners of the business, thereby diminishing management, control and value.
2. Valuation is set not only for purposes of a sale, but also for estate tax valuation purposes. Privately owned businesses are notoriously difficult to value. Your idea of your business’s value at your death may be much lower than the IRS’s. If you haven’t created a binding process for valuing the business, the IRS is free to impose its own determination of value. Take the initiative by designing a valuation appraisal process in your buy/sell agreement.
3. The terms and conditions of any transfer of stock, including interest rate, length of buyout period, and security can be fixed. In addition, where possible, the transfer can be funded. The agreement provides a clear estimate to a departing shareholder of how much money he or she will receive and how often. Likewise, the remaining shareholders know in advance the extent and duration of their buyout obligations. This allows both parties to plan their respective futures.
Had Tom and George created a buy/sell agreement with terms like these, a valuable business could have been transferred successfully. That transaction would have benefited Tom, George’s estate (family), Acme’s employees, customers, vendors and community.
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