If you are like most private business owners of a closely held or family-owned business, the illiquid value of your business interest represents a substantial portion of your net worth. Do you know what would happen to this ownership interest if you were to die or otherwise depart the business? If you answered ‘no’ to this question, then the chances are you do not have a buy-sell agreement, or your buy-sell agreement was drafted so long ago that it may not work as originally intended. If this applies to your closely held or family-owned business with two or more owners, now is the time to give some thought to preparing, or updating, your buy-sell agreement.
Buy-sell agreements govern how ownership will change hands if and when something significant, called a triggering event, happens to one or more of the owners. This right to buy or right to sell may arise under a myriad of pre-determined conditions, including a bona fide third-party written offer, retirement, disability, death, divorce or the dismissal of an owner as an employee. From a departing owner’s viewpoint, a buy-sell agreement provides a favorable price for an otherwise unmarketable asset. This can be particularly important for the family of a deceased owner. A buy-sell agreement allows owners to establish the value of their shares prior to their death. This is preferable to having a personal representative negotiate the value of the deceased owner’s shares, especially since the personal representative will likely be under pressure to liquidate these shares to pay taxes and expenses, and to fund distributions from the estate. From the remaining owners’ viewpoint, a buy-sell agreement prevents undesirable third parties, such as a surviving spouse or child or a creditor of the deceased owner’s estate, from becoming co-owners of the business.
There are three general categories of buy-sell agreements. The first type of buy-sell agreement is a cross-purchase agreement, whereby the remaining owners agree to purchase the departing owner’s shares. These agreements are often funded by life insurance on the lives of the owners. Cross-purchase agreements work well for relatively small businesses with two or three owners but quickly become unworkable as the number of owners increases and the market value of the business grows. The second type of buy-sell agreement is a redemption agreement, whereby the business agrees to purchase the departing owner’s shares. Funding may be provided through the purchase of life insurance, third-party financing, the departing owner or cash on hand. The third type of buy-sell agreement is a hybrid agreement, whereby the business has a right of first refusal to purchase the departing owner’s shares. If the business declines to exercise this option, then a right of second refusal to purchase the shares is typically offered to the remaining owners pro rata to their existing ownership. Funding is provided through a combination of self-financing by the business, notes from selling owners and life insurance.
In addition to providing a right to buy or sell shares pursuant to a triggering event, a buy-sell agreement determines the value of the departing owner’s shares. There are three general methods for setting the purchase price upon a triggering event. The first method for setting the value of a departing owners’ shares is to use a fixed price. A fixed price buy-sell agreement is easy to understand, easy to negotiate and inexpensive to carry out. The primary disadvantage of fixed pricing is that it is likely to go out of date within a short period of time. Although fixed price buy-sell agreements often call for the owners to revise the agreed upon pricing at regular intervals, in practice, this requirement is rarely followed.
The second method for setting the value of a departing owner’s shares is to establish a formula for fixing the share price. These formulas are generally based on book value or earnings. Similar to a fixed price buy-sell agreement, a formula price buy-sell agreement is easy to understand (at least initially), easy to negotiate and inexpensive to carry out. The disadvantage of formula pricing is that a formula is unlikely to provide consistent and reasonable valuations over time. There are a wide variety of potential developments for any given business, and a formula that works initially is bound to go out of date.
The third method for setting the value of a departing owner’s shares is through the use of an appraisal. Although it is more expensive to carry out than a fixed price buy-sell agreement and formula price buy-sell agreement, an appraisal buy-sell agreement will not go out of date and is more likely to lead to an equitable outcome when a triggering event occurs. When preparing an appraisal buy-sell agreement, the owners should determine the process for selecting the appraiser(s), who will participate in the procedure, how disagreements will be handled and who will bear the costs of appraisal. Prudent owners may even choose to have an appraisal when the buy-sell agreement is prepared or updated so that all parties understand the valuation process going forward.
Buy-sell agreements are often overlooked by business owners. This should not come as a surprise given that these agreements force owners to consider their potential disabilities, firings, retirements and deaths. While it may be human nature to want to avoid these topics, the lack of a buy-sell agreement, or an outdated buy-sell agreement, can have disastrous consequences for departing and remaining owners alike.
Joseph Heck is an attorney at Fryberger Law Firm. He can be reached at Fryberger’s Cloquet office at (218) 879-3363.
The material in this article is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.