For closely-held businesses with multiple owners, it’s certainly a best practice to have a buy-sell agreement signed and in place.
A buy-sell agreement is a contract between the co-owners of a business which stipulates the terms and conditions for the buyout of an interest in the company should one of the owners need to leave. Simply put, the agreement acts as a sort of “pre-nup” between the owners that addresses the exit conditions in the event of an owner’s death, divorce, disability, personal bankruptcy or violation of a company contract or policy.
A primary benefit of these agreements is the smooth succession of business ownership, especially in unforeseen circumstances such as death or disability. Since the buyout criteria was agreed to in advance by all of the owners, there should be less confusion and disagreement when an exit situation presents itself. Another benefit can be found in the creation of the agreement itself, as it forces owners to discuss and evaluate the scenarios involved with a buyout and allows them to iron out any issues in advance to minimize future conflicts.
However despite their obvious importance, many companies do not have buy-sell agreements in place or have agreements with terms that may no longer be applicable for the current state of the business and its ownership. Read on to learn some of the best practices for business owners to consider when drafting or updating a buy-sell agreement.
Don’t Be Afraid to Ask for Help
Business owners should not hesitate to enlist the services of a lawyer, CPA and valuation expert when creating or evaluating a buy-sell agreement. The agreement can have far reaching effects not only for the owner’s personal financial situation but also for the future of the business itself.
A competent professional team can make sure that the agreement is solid, that it addresses the needs and wishes of the owners and that it avoids any significant pitfalls down the road. A properly prepared buy-sell agreement can potentially save a business thousands of dollars in future legal and other costs as well as save owners from future headaches.
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Agree on a Valuation Methodology
Perhaps the most important part of a buy-sell agreement is determining how the business should be valued. Business valuation is very subjective and is often the cause of most disputes in the buyout process, so it is vital that owners are in agreement with how the company should be appraised.
Some buy-sell agreements contain an agreed-upon valuation formula (such as a multiple of sales or earnings) that can be used to calculate a value for the company at the time of the trigger event. While using such a formula can be straightforward and easy to apply, this approach may ignore important aspects of the business (such as an intangible brand) that could have a significant impact on the value.
As such a best practice is typically to have a business valuation expert (such as a CVA) perform a valuation of the business. A professional valuation can provide an independent opinion or estimate of value that incorporates all the relevant aspects of the business.
The valuation can be performed as needed based on the owners’ exits; however ideally a valuation would be performed at the initiation of the agreement and then annually thereafter. Having a regular valuation provides a current value in the event of a sudden owner exit and also allows owners to monitor the changes in the business’s value for their own personal financial and estate planning purposes.
READ MORE: Business Valuation: When Businesses Need One and Why to Use a CVA (Video)
Determine the Buyout Funding
Since the trigger events in a buy-sell agreement are typically unpredictable (such as death or disability), a company and its owners might be caught unprepared to fund the buyout of the departing owner’s interest. Thus, a buy-sell agreement should specify how the buyout should be financed.
Owners may wish to take out life insurance policies to cover the cost of a buyout in the event of an owner death. If the company will be buying back the interest, the agreement should stipulate where those funds should come from (such as from the business’s working capital or a draw on a line of credit).
Including an installment payment plan in the agreement is another way that the financial burden of the buyout could be lessened for the company. By addressing these issues up front in the agreement, the business and its owners can be better prepared for the buyout.
Consider the Tax and Legal Implications
There are likely to be significant tax implications for the exiting owner (or his estate) as a result of the buyout. In addition there could be legal issues that arise as a result of the exit, especially in the case of an owner divorce or bankruptcy.
When developing a buy-sell agreement, the owners should consider the potential tax and legal impacts of a buyout on the business and on their personal situation and incorporate terms into the agreement that offer protection from unfavorable situations. Buyouts should be structured to minimize the tax burden on the exiting owner, and clauses can be included that shield the business and its owners from divorce or bankruptcy court proceedings. As mentioned earlier, owners should engage with a trusted lawyer and CPA to make sure the tax and legal concerns are properly addressed in the agreement.
A good buy-sell agreement can offer business owners peace of mind and help them to avoid future conflict and retain control of their companies. Once in place, agreements should be reviewed on a regular basis or especially when there is a major change in the business or an anticipated change in ownership.