Hey, Partner, We Need a Buy-Sell Agreement

If you have partners, you need to consider what will occur when a partner wants to retire or suffers death or disability. One way to minimize chaos and control the order of events is to design and execute a buy-sell agreement. Desirables include:

1. Preserve control by restricting transfers or sales of company stock to persons outside the company or owner’s immediate family.
2. Protect business assets and ongoing operations.
3. Provide cash or other assets (e.g., life insurance proceeds or promissory notes) to the retiring or disabled owner or family of the deceased.
4. Establish a method for determining the value of the business for estate tax purposes and transfer or sale of company stock.
5. Assure sufficient liquid assets are available to fund a buyout, pay federal and state estate taxes, and meet financial needs of surviving family members.
6. Reduce some of the risks inherent in grants of incentive stock awards to key employees.

Structuring a Buy-Sell Agreement

A buy-sell agreement can protect business value, reduce the likelihood and severity of shareholder disputes, and provide for continuation of the business beyond its current ownership. A buy-sell agreement can also be designed to provide income to the retiring or disabled partner or to the family of a deceased partner. Initial questions that need to be considered are:

• Should the buy-sell be cross-purchase or stock redemption? In a cross-purchase, share buyouts are affected by one or more partners buying the shares of another. In a stock redemption, the corporation does the purchasing.
• Should the buy-sell be funded with proceeds from life insurance on each owner’s life, and what cautions should the surviving owners take to assure payment?
• How will the business, or partial ownership interests in the business, be valued under the buy-sell agreement and will it conform to IRS valuation guidelines?
• Is the valuation method dynamic so that the valuation of the business changes as the business changes?
• Will changes in the business value trigger adjustments to mechanisms that will provide buyout funds?
• If insurance is the financing vehicle, should the premiums be paid by the company or the individuals?
• How can you structure the insurance policies to reduce or eliminate income and estate taxes?

Buy-Sell Agreement Checklist

Here are major items to include in a buy-sell agreement.

• Names of individuals, number of shares (ownership percentage), purchase price, and the corporate or partnership entity involved in the buy-sell arrangement.
• When the agreement will become effective: death, termination of employment, retirement or disability.
• Method of stock purchase: stock redemption, cross-purchase, combination of both, or survivor’s option plan, where the decision is not made until death or retirement of the owner.
• Buy-sell value (price) and method for updating the value over time, preferably every year or two. Keep in mind that the value of many closely held businesses can increase (or decrease) substantially from year to year.
• How the owner(s) will be paid for the stock: life insurance proceeds, promissory notes, other owners’ personal assets, company cash or a combination.
• Circumstances in which the ownership position (i.e, actual shares of common stock) can be hypothecated or otherwise encumbered for loans or other purposes.
• Whether the buy-sell is a legal obligation or only an option to buy or sell.
• Conditions in which the buy-sell is to be amended or terminated. Written approval of all parties or just a majority of shareholders or shares outstanding.
• State law governing the agreement and any alternative dispute resolution provisions.
• “First-offer” or “right of first refusal” clause stating that before a stockholder can sell his or her stock, it must first be offered to the corporation and/or other stockholders.
• Clause binding future owners to the buy-sell agreement (i.e., covering stock options issued to key executives and other employees).
• Provision for an independent trustee if the purchase price of shares is substantial and funded by life insurance. Recommendation: Use a law firm or financial institution to make sure insurance proceeds are disbursed directly to your designated heirs/beneficiaries.

Valuation Methods to Use in Buy-Sell Agreements

Be aware that the IRS can challenge the price at which shares change hands. This occurs most often when no documentation exists to support the business’ value and price per share. Documentation is particularly important if the buyout is substantial. You can support your valuation and buy-sell price by using one or more of the following accepted valuation methods.

• Book Value: Simply the company’s total assets less total liabilities as presented on your financial statements. Tangible net book value also could be used. It excludes all intangible assets such as capitalized financing costs and goodwill.
• Adjusted Book Value: Amends the company’s book value to reflect any difference between book value and fair market value of certain assets and liabilities. For example, book value of depreciable assets such as buildings or equipment are often understated. The adjusted book value method usually renders a value higher than reported book value.
• Replacement Cost: Adjustment of all assets to their replacement value and then subtraction of all liabilities. Usually leads to a valuation that exceeds that of book value and adjusted book value.
• Price-Earnings Multiple (P/E): Value of the business is determined by applying a multiple to earnings of the business. The multiple, and how to apply it, is described in the buy-sell agreement. Important elements should be stipulated, such as type of earnings (pretax, after-tax, EBIT, EBITDA); earnings period (most recent 12 months, most recent fiscal year, average of the past four fiscal years); how debt of the business will factor into the valuation; and what to do if earnings are zero, near zero or negative. Earnings-based methods typically yield valuations far greater than balance sheet methods during periods of high profits. The reverse is true, of course, during periods of low or no earnings.

Your accountant can help you design and apply your valuation method. You might also use two or three of the methods and take the highest average or weighted average.

Additional Considerations

You should take other precautions to assure the buy-sell agreement’s validity and effectiveness. These ideas apply to both existing and new buy-sell agreements.

1. Each stock certificate subject to a buy-sell agreement should have a written legend stating such on the face of the certificate.Example: “These shares are subject to a buy-sell agreement dated ______________.”
2. If the company is to purchase shares, you will have to provide for it in the corporate minutes and possibly obtain approval, in advance, from any minority shareholders. Check with your lawyer.
3. The signed buy-sell agreement must be bona fide, entered into in good faith, and effected on an arm’s-length basis, particularly when transacting with family members. For example, you can’t set a low value on a small portion of your company stock and expect the value to apply to the remaining holdings for estate tax purposes.
4. The buy-sell price per share must be reasonable and legally binding. It cannot be a device to transfer ownership to family members at less than its full fair market value.
5. Include provisions that will aid if an active partner becomes disabled.
6. To defer taxes, you might want to consider building in an installment sale provision. Keep in mind, though, that delaying payments could increase risk of nonpayment.
7. In crafting an effective buy-sell agreement, consider also seeking advice from a mergers & acquisition expert and/or business valuation expert.

Financing the Buyout of Your Stock

Establishing the procedure by which stock is bought and sold on the departure or death of a shareholder is the first step in protecting the company. Providing money to carry out the procedure is the second.

You can’t assume that surviving owners will have enough personal liquidity to finance the purchase on their own or that they will be eligible to borrow the required amount. The price tag on shares in a profitable, growing company can be substantial. Nor can you assume the company will have sufficient liquidity or access to capital to fund the purchase on its own. You might want to consider another approach for providing the needed money.

Life insurance. Life insurance on the life of each owner can supply all or part of the needed cash. In the case of a stock redemption plan, the company buys the insurance and names itself beneficiary. A cross-purchase agreement could incorporate life insurance by each shareholder buying a policy on the other(s). Any insurance payout is then used to purchase the deceased owner’s interest.

How much insurance? Shares to be covered by insurance on each owner’s life represent a certain percentage of the company’s value at the time the insurance purchase is made. For example, if each of four stockholders owns 25 percent of a company valued at $1.2 million, then $300,000 life insurance must be purchased on each owner’s life. To reflect future increases in the value of the stock, the dollar amount needed to purchase the shares should be adjusted periodically along with the amount of life insurance relied on to finance the purchase.

Joint life or first death. Another possibility, where several owners have roughly equal shares of the company, is joint life or first death insurance. The policy covers all of the owners but pays the life insurance proceeds when any one of the parties dies. The insurance proceeds can be paid to the company or to the others in the group, depending on how the agreement was set up. Of course, if this type of insurance is used, it will be necessary to work out a new arrangement and take out a new policy after the death of any one of the owners.

Covering a shortfall. If life insurance is used, consider including a provision that addresses how a shortfall will be bridged. For example, if the policy pays $200,000 but the buyout is $300,000, should the surviving partner be allowed to pay off the shortfall over a period of years? Will an interest rate apply?

Buy-Sell Taxation

If a buy-sell agreement is funded with insurance, it is critical it be structured in a way that minimizes taxes. Generally, life insurance premiums are not tax deductible and life insurance proceeds are not taxable income when received by the beneficiary. If the company is the owner and beneficiary of the life insurance policy underlying a stock redemption plan, there is usually no taxation. It’s straightforward — the premiums are not tax deductible by the company, so the proceeds received are not taxed.

Problems can occur when the company is not listed as policy owner, but the company owner is. When the company owner dies and the company uses insurance proceeds to acquire stock from the deceased owner’s estate or heirs, the proceeds will be included in the value of the estate of the deceased. This could trigger significant, unnecessary estate taxes.

Estate taxation is complex. Talk to your tax attorney and financial advisor about the proper structure of your buy-sell agreement and related insurance policies.