Buy-Sell Agreements Need Regular Check-Ups

By: David R. Foster, JD, AEP, CLU, CHFC, CAP FLMI

Buy-Sell agreements are commonly implemented by business owners to place legal limitations and guidelines on future transfers of their business interests, thereby securing a smooth transition of the business. Properly documented buy-sell agreements also help to assure the continued success of the business by avoiding conflicts between business owners.

There are numerous issues to consider when designing buy-sell agreements including valuation of the business, terms of a sale, events that will trigger a sale, whether these events should create an obligation or a right to purchase and sell a business interest, where the funds will come from to complete the sale, and how to minimize the tax implications of a future sale, etc.

The following is a list of considerations when implementing buy-sell agreements:

Existing Restrictions & Agreements

It is important to review governance documents, such as articles of incorporation/organization, bylaws/operating agreements, and loan documents or other significant contracts, to determine how they affect the buy/sell agreement, or vice versa. If various documents have conflicting terms it may cause conflict among owners should a transfer of ownership be considered.

Type of Buy-Sell Agreement

Selection of the wrong type of agreement can create unintended and unwanted results.  Considering your specific business, ownership structure, entity type, etc., is it more appropriate to have owners buy each other out or to have the business redeem shares or purchase a partnership interest? Tax issues (discussed below) may play a part in making the best choice, but there are other considerations. For example, if a business with 6 shareholders and a cross-purchase buy-sell agreement want to fund their obligations with life insurance, it would require 30 separate policies (very inefficient pricing and an ongoing administrative burden).

Improper Selection of Triggering Events

If the buy-sell agreement doesn’t cover a particular event, the owner or the entity may have no rights in such a situation.  Consider the possible applicability of triggering events beyond death and disability. These may include involuntary (or voluntary) termination of employment, divorce, loss of a professional license, and bankruptcy to name a few.

Rights and Obligations Following Occurrence of a Triggering Event

The rights and obligations granted to owners when a triggering event occurs may take many forms. The event may grant owners a right they may elect to act upon or it may require action. There is a huge difference between the terms “may” and “shall” when it comes to the obligations they trigger. Be careful with so-called “wait-and-see” buy-sell agreements that appear to provide flexibility as these often turn into “wait-and-sue” buy-sell agreements because there are no true obligations.

Valuation Issues

This is probably the number one problem area with buy-sell agreements. Be sure to ascertain the standard and level of value for the interests. The agreement may state a fixed value (which needs to be updated at regular intervals), a stated formula (i.e. 2 times EBITDA), or may leave the valuation up to appraisers should a triggering event occur.  If a formula is used, understand the formula’s basis, play out the scenarios, and try to develop a backup method. If appraisers are to be brought in, make sure both the buying and selling parties are permitted to bring in their own appraisers and that both parties are on equal negotiating terms. In addition, there is no law against setting different valuation methods based on different triggering events. For example, the price paid for purchasing shares from the spouse of a deceased shareholder does not have to be the same price paid for purchasing the shares of a shareholder who was terminated for cause. Consider applying a discount based on certain triggering events.

Funding Issues

If the buy-sell agreement doesn’t cover a particular event, the owner or the entity may have no rights in such a situation.  Consider the possible applicability of triggering events beyond death and disability. These may include involuntary (or voluntary) termination of employment, divorce, loss of a professional license, and bankruptcy to name a few.

Financing Terms

Many buy-sell agreements contain installment payout plans for payments of the purchase price. In determining the details and flexibility of installment payments, pay close attention to the size of the projected installment payout relative to the amount of the future expected cash flow from the person who is entitled/obligated to purchase. If the buy-out is to be over a period of years consider setting interest at a rate based on an established lending rate such as Prime versus setting a fixed rate (may be appropriate today but highly inappropriate in the future).

Failure to Coordinate Related Properties

Sometimes the business is dependent on related properties not owned by the business.  Related property can include life insurance policies on the life of the selling owner, interests in land (such as property on which a business operates), intellectual property, leases or other contractual obligations.  It is important to analyze the subject company to see if it is reliant upon property that is owned by others and the terms of those arrangements.

Failing to Consider Tax Issues

There are a host of tax issues that need to be considered when designing and funding a buy-sell agreement. For example, if a business is owned by family members a redemption of stock may not qualify for capital gains tax treatment (family attribution rules). The surviving shareholders who take over a deceased shareholder’s shares in a C corporation stock redemption buy-sell agreement will not receive an increase in basis. The same may be true for owners of an S corporation unless they utilize a 1377 election. A trusteed buy-sell agreement may trigger a “transfer-for-value” under IRC 101(a)(2) which will cause the death benefits to be taxable.

Consider Potential Future Shareholders (Especially Minor Children)

A boilerplate buy-sell document may be too restrictive in that it does not permit a shareholder to pass on their shares to future generations who want to be involved in the family business. Consideration should be made as to whether or not to allow such transfers with approval of the remaining shareholders (or without).

Forgetting That Minority Shareholders Have Substantial Legal Rights

Various states have minority shareholder oppression laws on the books that give minority shareholders legal rights that may not be overlooked. Many conflicts arise when a non-active owner sees the business as a means of generating annual income without an understanding of the business operations. For example, active owners may see a need in a particular year for using profits to reinvest in the business at the expense of distributing dividends. This may not go over well with a non-active owner who just wants income and may lead to conflicts and lawsuits.

Businesses do not stay stagnant over time, and neither should the buy-sell agreement that controls the details of ownership changes. As shareholders are added or removed, the value of the business increases or decreases, properties are purchased or sold, the buy-sell agreement should be reviewed on a regular basis to assure it continues to represent the goals of the owners.