What happens if you (or a co-owner of your business) die, become disabled, decide to retire, or have a HUGE disagreement on a business decision? A properly structured buy/sell agreement could provide the answers.
Buy/sell agreements can either be structured as an agreement by and among co-owners (a “Cross-purchase”), as an agreement between an owner and the business itself (a “Redemption”), or as a combination of the two (if the other owner or the company does not buy the other will, sometimes called a “Wait and See”). The best type of buy/sell agreement of any particular business often depends on the classification of the business for tax purposes , the form of funding of the agreement as well as the nature of the business itself.
The way a buy/sell agreement operates is that when a “triggering event” occurs, one of the parties to the agreement (or the company itself), either:
• must buy the selling owner’s interest or
• may buy the selling owner’s interest .
“Triggering Events” can include, but are not limited to: the death, disability or retirement of one or more of the business owners.
A business disagreement could also be a triggering event, as could one (or more) owners seeking to “buy out” the other owner(s). Buy/sell agreements which take effect in these situations have the result of resolving business decisions via the purchase/sale of the interest of one (or more) of the parties.
A “right of first refusal” is a buy/sell agreement whose triggering event is the receipt by one party of a bonna fide offer to sell their interest in the business to a non-owner. The recipient of the offer is then required to give the other owner(s), or the company, the right to buy the interest on the same terms being offered by the non-owner before completing the sale. A potential pitfall to entering into a “right of first refusal” is that it may of itself discourage the making of offers because:
• If the Non-owner becomes the purchaser of the interest, the Non-owner will be dissatisfied with the transaction because they paid more than the “insiders” think the interest is worth; or
• If the Non-owner’s proposal is “taken” by the insiders, the Non-owner will be dissatisfied because they didn’t get the benefit of their bargain; they simply made a “deal” for someone else.
One of the most important aspects of a buy/sell agreement is the method of arriving at a price. Most often, the price is determined by a formula. There is no one “right” formula. Common formulas include (but are not limited to) a proportionate share of:
• An appraised value of the business,
• The book value of the business,
• The book value of the business with an adjustment for appreciated assets,
• A multiple of book value,
• A multiple of earnings, or
• A capitalization of earnings.
Terms of payment of the purchase price are also a topic for consideration. Payments can be set up in installments or paid in a lump sum. Often in the case of a buy/sell agreement which is triggered by death or disability, the payment terms are designed to coincide with the terms of insurance policies purchased to “fund” these payments.
A properly drafted buy/sell agreement can address difficult situations before they jeopardize the future of the business.