John and Frank are co-owners of the business they founded fifteen years ago. The business started with little cash, one customer, lots of hard work, and no employees. Today the firm generates millions in revenue from thousands of customers, has over a hundred employees, and pays considerable distributions to the owners. In short, their business is valuable.
But John wants to retire from the business and exit completely to spend more time with his grandchildren while at the same time capitalizing on his years of hard work and dedication. Frank wants to keep working but doesn’t have the funds to write John a check for his stake in the business. Mark, a key employee who John and Frank greatly trust expressed interest in buying John’s ownership stake, but he doesn’t have the financial resources to write John a check.
The owners turn to the operating agreement for instruction, which hasn’t been looked at since they started the business, but it provides no guidance for transitioning ownership. Upon further examination, their operating agreement provides no clear outline or process for any owner transitions such as an unexpected death, divorce, quitting, retirement, or problematic behavior necessitating the dismissal of an owner. John and Frank have remained close friends over the years and so they feel they haven’t needed to discuss these matters. However, the key employees interest in purchasing John’s shares makes issues like divorce or disability much more real.
John and Frank are thankful nothing like the previously mentioned issues have happened in the last fifteen years of their partnership, but now that the firm is considerably more valuable than when they started, concerns among John and Frank are beginning to materialize about their in-place buy-sell agreement, or lack thereof.
The above story is fictional but can be applied to many businesses I have seen over the years. Generally, businesses get started with little attention to the operating agreement, or shareholder agreement, on matters related to owner transitions. Furthermore, these can be uncomfortable conversations to have and many busy owners shy away from these crucial conversations. However, these are important matters to address, because they can materially affect an owner’s financial outcome depending on why they leave the business (i.e. retire, quit, death, disability, divorce, etc.).
Proper buy-sell agreements address many real world and worst-case scenarios that firms with multiple business owners face.
What is it and Why Should A Business Owner Care?
Buy-sell agreements are the policies governing how ownership will change hands among multiple owners of a business based on certain events, called trigger events, that happen to one or more of the owners.[1]
For instance, if an owner is disabled and can no longer work (trigger event), what will happen to their ownership stake? Will the company buy the shares from the disabled owner? Will the remaining shareholders step in and buyout the owner? If so, what price should they pay and how should that price be determined? Where will the funds come from to purchase the shareholders stake? Insurance? Corporate Funds?
As you can see the exit of an owner can lead to serious questions about ownership transfer, and a detailed buy-sell agreement can address many of the concern’s owners will face when shares inevitably change hands.
Buy-sell agreements can be a single agreement, sometimes referred to as a shareholder agreement, or sections of an agreement in a business operating document. Either way, consulting an attorney to formally write a buy-sell agreement is necessary.
We are not providing legal advice, but advising from the standpoint of a business valuation expert who will be responsible for following the buy-sell agreement once it is triggered. As such, our practical experience guides our motivation to advise business owners on creating effective buy-sell agreements.
Best Practices
There are many approaches to constructing a successful buy-sell agreement for your business. Chris Mercer, a fellow business valuation professional, has written extensively on buy-sell agreements and says a successful buy-sell agreement integrates the following [1]:
1. Require that all stakeholders agree at a specific point in time – Meaning that all stakeholders should get on the same page!
2. Relate to transactions that may or will occur at future points in time between shareholders or between the shareholders and the corporation – Owners should openly discuss all potential reasons a transaction of ownership may occur in the future such as divorce, death, disability, retirement, etc.
3. Define the conditions that will cause the buy-sell provisions to be triggered – The ‘trigger events’ include death, disability, retirement, divorce, quitting, etc. by an owner. Decide which events cause the buy-sell agreement to be triggered. This means deciding when the agreement should be used to facilitate the transfer of shares from one or multiple owners to another owner or the company. I recommend the more trigger points the better because it leaves less room for subjective judgement down the road.
4. Determine the prices at which the identified future transactions will occur – This is especially important time to consult a business valuation expert. Owners can select the value to be based on price per share, per unit, or per member interest. Furthermore, you will need to determine the standard of value the appraiser will use, such as fair market value. These are especially important questions that must be addressed on an individual basis.
5. Provider of funding so that the contemplated transactions can occur on the terms and conditions satisfactory to the selling owners and the company – This is usually overlooked but is very important. Knowing who will fund the transaction in advance allows for a smoother transition. The business can fund the purchase, or an insurance policy can do the same. You must determine what is right for your business.
6. Satisfy the business requirements of the parties – All owners should be reasonably satisfied with the agreed upon document. If the parties are at odds, than no agreement, regardless of how well it was written will hold.
7. Provide support for estate tax planning for the shareholders – This is a more advance discussion, but a buy-sell agreement can be used for estate tax planning for the owners. The agreement should conform with Internal Revenue Service (IRS) guidelines if the owners choose this path.
8. Satisfy the legal requirements related to the buy-sell agreement – Since an attorney will need to formally prepare the buy-sell agreement, the agreement should be legally binding and satisfy all legal and / or regulations applicable to the businesses operations.
For more information on buy-sell agreements please visit Chris Mercer’s website (www.buysellagreementsonline.com)
Next Steps
There are many steps in the process of developing an effective buy-sell agreement for your business. Before you can dig into the details of the agreement you first need to see what your current agreement states and get the remaining owners on board. To begin follow these initial steps:
– First, review your current buy-sell agreement, if one exists. The agreements can be in the operating agreement, by-laws, or shareholder agreement.
– Second, gather the owners, via phone call or in-person, to initiate the conversation and begin discussing what issues may require a transition (death, divorce, disability, quitting, retirement, etc.) of the shares in the business. This website provides a buy-sell agreement checklist that is helpful and FREE!
– Third, discuss openly how you would finance each ownership transition. Do you want the company to fund the buyout(s) or will the owners obtain insurance policies for each other? This often overlooked step is crucial to building an effective buy-sell agreement.
– Once you understand your current buy-sell agreement and have the owners on board to make any necessary changes to the agreement, you now have a beginning framework to work with your attorney and business valuation expert to help draft an effective agreement.
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[1] Mercer, Z. Christopher. Buy-Sell Agreements for Baby Boomer Business Owners. Memphis, TN. Peabody Publishing, L.P. 2013.
