Business ventures are extremely valuable entities. Financial strength after so many years of management is not the only driving factor of value, however. Often, the most valuable aspect of a company is the partners who oversee it, individuals who have dedicated immense amounts of resources into its successful cultivation and positive reputation. When circumstances lead to the vacant position of an individual who owns a portion of a company, a lack of legal oversight can lead to a variety of disadvantageous outcomes for all parties involved. Some negative outcomes could include vulnerability to the strength of the business, and a long list of questions that could lead to many financial headaches.
So, What Is a Buy-Sell Agreement?
The good news is that there is an option to put legal contracts in place that dictate how a person’s share of a business should be handled or distributed in the case that the individual leaves the position due to unforeseen circumstances such as death or retirement. This is called a Buy-Sell Agreement, whereby the shares of a company that are owned by an individual who has left a position empty, are sold back to the company or distributed to particular individuals under a previously agreed upon structure/formula. There are a few different types of buy-sell agreements, however before we go into more detail, it’s important to understand a more technical explanation for the reason behind these agreements.
When a person, for example, passes away and leaves their portion of a business behind without a contract in place, many specific problems arise for their business as well as the surviving heir to that individual’s assets. To begin, the valuation of a business after a person leaves could be much less than it was previous to their untimely exit of the position. Additionally, the portion of the business inherited by the individual’s heir may be going to someone who has no expertise or interest in fulfilling the duties of the position themself. In order to bypass this issue and regain complete control of their business, it becomes necessary and advantageous for the remaining owners of the company to buy the previous owner’s remaining shares of the business. Depending on the size of the business, this amount could be quite large, however, and could put their business at financial risk in order to reclaim them, and could just as well leave the heir with nothing.
Let’s say on the other hand, that a buy-sell agreement was put in place before the partial business owner’s death. In this case, the business is contractually obligated to repurchase the individual’s share’s from his/her heir which most commonly happens to be family. The purchase happens at a predetermined rate that varies in particularity depending on the agreement. In order to cover the cost of repurchase, however, companies will often put life insurance policies on fellow shareholders in order to ensure that they will be able to make the purchase, thereby also ensuring the family of the deceased individual is also receiving money for their family member’s portion of the business.
Types of Buy-Sell Agreements
There are two main types of buy-sell agreements that are used today. There are also a variety of valuation mechanisms that are chosen from and stated within the agreement in order to determine how the value of the business should be assessed when the individual does leave the company. Depending on the structure and size of your company, as well as how your business shares are distributed and owned, your agreements will take one of two forms: a Cross-Purchase Agreement or a Redemption Agreement.
Cross-Purchase Agreements are utilized in circumstances where multiple company owners or shareholders purchase the interest or shares of a previous owner who has died, become incapacitated, or retired. Specific to this type of agreement is a framework that is established to determine how the shares should be distributed or otherwise purchased by members, for example by distribution proportional to each shareholder’s stake in the company.
In order to put a contingency plan in place in the occurrence of a death of a partner, partners will purchase life insurance policies on one another in order to ensure that they’ll have the capability of purchasing their allotted portion of shares. This also ensures that the family of the deceased individual will derive some monetary value from the passing of their loved one.
A benefit of these life insurance policies is that partners don’t have to pay taxes on the money that is paid out to them. This can provide even further financial relief for the business in times when they may be under particularly challenging circumstances. However, insurance policies can lead to a variety of difficulties as well. Depending on the ages of the partners, younger partners may need to pay much higher premiums on the life insurance of older or less healthy partners which can lead to unfair payment rates between owners. Additionally, in situations with more than just a few partners, the processes and number of insurance policies that must be purchased become unwieldy. For example, in the circumstance of a 4-way partnership, there are already 12 insurance policies in use.
With just a few differences from Cross-Purchase Agreements, Redemption Agreements are more commonly sought after in business situations where there are many partners, so as to alleviate the trouble of partners buying an excessive amount of policies on one another. The business entity itself buys a single policy on each of the partners in respective proportion to the amount of stake each partner has. In the event of a partner’s death, the business entity collects the insurance and buy’s out their portion of holdings.
These insurance policies are crucial to allowing businesses to refrain from liquidating or selling company assets in order to stay afloat and in control of their business. An advantage to the purchase of a redemption agreement is that cost is split evenly between shareholders based on their proportion of stake holdings. This thereby alleviates the extra cost that may have been paid by younger/more healthy partners in the Cross-Purchase Agreement. One potential drawback, however, in contrast to Cross-Purchase Agreements, is that the money collected by the business for an insurance claim can be seized by creditors for any debts that the business may have.
Each type of agreement has its strong and weak aspects, and ultimately the decision should be made on a case-by-case basis of your specific businesses’ needs and size. No matter the type of agreement you move forward with, it is helpful to understand how much coverage should be purchased for each partner in the first place, utilizing one of three company valuation methods: Book Value, Market Value, and Capitalization of Earnings.
Determining the amount of insurance to buy can first be based on the Book Value of your company. This valuation method simply involves subtracting the company’s liabilities from its assets. This particular form of valuation is then good for companies with many physical assets, rather than service-based industries such as a law firm. Market Value is a different valuation method, which takes into account how much an individual would pay in order to buy the company. More often than not, Market Value is higher than Book Value and therefore is more advantageous for businesses to use because this could reduce the risk of being underinsured. Capitalization of Earnings takes into account the annual earnings of the business as well as forecasted future earnings. Considering it doesn’t take into account the value of current physical assets, this type of valuation model is good for service-based businesses without a lot of physical capital.
An important aspect to include in the Buy-Sell Agreement is a specification indicating how the business should be evaluated at the point an individual leaves the business. This helps to determine the value of their share of the business, and how much needs to be paid to the family of the deceased individual in order to reacquire and distribute their holdings of the company. There are three particular valuation mechanisms for this process: a Fixed Price Agreement, a Formula Agreement, or a Business Valuation Agreement.
Fixed Price Agreement
Within this agreement type, a specific dollar amount/value is stated that will be paid in the future, taking into account the valuation of the business at the present time of the formation of the buy-sell agreement. The advantage to this is that all the partners are on the same page, and know exactly what the buy-sell price will be down the road. On the other hand, this fixed price could become outdated down the road due to fluctuations and growth of the business. Additionally, if the exact value of the company is not known before the agreement is made, the buy-sell price could be rather unrealistic.
In this type of agreement surrounding the valuation of the company when an individual leaves a vacant role, a number of company operations are formulated to create a determination of the company value at the point the individual leaves. The advantages to this type of agreement are not only that the specific calculations to determine the value of their shares is known to all, but also that the valuation is not static or stuck in time. Through time, the value of a business will no doubt change (whether in growth or retraction). With the option to follow key metrics of the business success, the valuation of the individual who left the company will adjust to reflect the growth or downsize of the company and ensure that the share of their business is being purchased for a fair amount that is not over, or under the true value of their shares. Despite this, there is no way to ensure that the chosen metric or formula will be an accurate reflection of the value of the business in the future.
Business Valuation Agreement
In this type of agreement, a process is outlined for pricing the valuation of the business in the future, rather than in the moment the agreement is made. This takes into account that the exact value of the company in the future is difficult or impossible to predict. When this takes place, it is not uncommon for a third-party expert to give their opinion on their valuation of the business, which takes the ‘guessing’ work and accuracy out of making this determination through the company’s own means. An advantage to this type of agreement is that lawyers are often familiar with the structure, and it allows for better accuracy. However, for someone who would like a better idea of what exactly will be happening in the future in the event that a partner must sell back their shares, it could be a point of relative uncertainty.
So when is the best time to put a Buy-Sell Agreement into place? The answer is long before it’s going to be needed. When these agreements are made well in advance, you manage to negate the risk of ulterior motives coming into play when a particular individual is vulnerable while still having stake in the company. When these agreements take place after situations such as death, not only are there potentially conflicting interests at play, but there is also an increased chance of the involvement of emotions in the processes, which can be straining for relationships.
Some of the conversations surrounding Buy-Sell Agreements may be around potentially sensitive subjects, and with so many technicalities to the process, it’s understandable that the process may seem a bit overwhelming. Understanding what these agreements are at a fundamental level, and then working with trusted professionals to help aid you through the process will overall be well worth the time and energy in the end. A small dedicated amount of time and money by the partners in your company could save a large high-pressure decision in the future that could be detrimental to the financial success of your business. If you have any questions about the Buy/Sell Agreement process, or what this agreement could afford you in the future, don’t hesitate to contact your advisor.
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