A buy-sell agreement is the most important legal document a closely-held or family business can hold. Without a buy-sell agreement, businesses face peril upon a triggering event such as an owner’s death, incapacitation, divorce, filing bankruptcy, desire to sell, or retire. The consequences of not having a buy-sell in these situations can and usually does lead to expensive litigation. The ultimate end includes the potential of losing the business during the personal and legal conflict. In general, the best time to create a buy-sell agreement for any business is before the first dollar of revenue is ever transacted; however, if a business does not have a valid buy-sell agreement, a buy-sell agreement can be created and agreed to at any time once the business is in operation.
Stock Redemption Agreement
A stock redemption agreement provides for the purchase of an interest by the entity itself, as distinguished from business associates. A corporate stock redemption plan, utilized mainly in closely-held corporations, provides for the corporation to redeem or retire the affected shares. A partnership redemption plan, referred to as an entity plan, provides for the partnership to retire the exiting partner’s interest under specific conditions.
The cross-purchase agreement takes the form of a contract among stockholders, wherein the stockholders purchase an exiting shareholder’s share of the business interest on an individual basis. Thus, a cross-purchase agreement among partners/shareholders provides that if one of the partners exits, the remaining partners/shareholders will receive the exiting partner’s interest in exchange for the price specified in the agreement.
In a mixed agreement, the entity is given the first option to purchase the shares of a stockholder. To the extent the shares are not purchased by the entity, they can be purchased by other shareholders usually in direct proportion to the ownership.
Basic Valuation Issues
When multiple owner businesses dissolve, under the default rules of the applicable state business laws, one owner or the entity must fairly compensate the exiting owner for his/her interest based upon the fair market value of that interest. Fair market value has been defined as the price at which property passes between a willing buyer and seller, neither under any compulsion to buy or sell, and both with knowledge of all relevant facts. This definition is extremely vague and has historically led to a great deal of expensive litigation in this country. Defining the actual method for valuation diminishes conflict regarding valuation when a triggering event happens and can lessen the impact of estate taxes when the buy-sell agreement is authored at arm’s-length. In any buy-sell agreement, there should be guidance regarding how the entity will be valued.
Common Triggering Events
Death: This event is nearly always provided for in any buy-sell agreement. The terms in this triggering event will provide for time of payment to the owner’s estate.
Disability: These terms will include determination of disability, time of payment to the owner, funding mechanism, and disability insurance.
Retirement of an owner: Generally, retirement triggers mandatory buyout of the retiree’s stock. In this case, funding and valuation are critical. Funding is critical in these cases in that no life insurance is available for the event.
Owner’s divorce or bankruptcy: Either of these legal actions can lead to problems and legal challenges from outside the entity.
Termination of the Employee: From time to time, employees are terminated from employment whether they are owners or not. Once again, a valuation method and payment terms should be listed.
A buy-sell agreement provides for smooth transition of a business interest by identifying triggering events, specifying to whom or to what the business interest must be sold, providing a mechanism to determine the purchase price, providing a funding source, and establishing a valuation for estate tax purposes. If your company does not have a buy-sell agreement, now is a great time to get one.
Dr. Basi has just completed a course on buy-sell agreements. It is being developed into a program for distribution to business owners. The program is one hour in length and contains a DVD and a workbook. Contact Trish at The Center for details on obtaining this program.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors