Successful business owners are known for being forward thinking. They are able to spot future opportunities, predict changing client needs, foresee potential challenges, and then plan appropriately to profit from these future opportunities and overcome the challenges.
Using the same skills, business owners can consider the eventual transition of their ownership interest and plan how to make it successful.
A key component of business transition planning is the buy-sell agreement. Buy-sell agreements are commonly implemented by closely held business owners to place contractual limitations and guidelines on future transfers of their business interests. Properly documented buy-sell agreements can allow for continued success of the business by avoiding conflicts between business owners. Each agreement can be drafted to accomplish the specific goals of the owners. Below is an overview of key considerations that may be addressed when constructing an agreement.
Structure of Buy-Out Terms
Factors such as the ownership structure, number of owners, entity type, tax issues, and the nature of the business can be taken into consideration when determining the specific transactions provided for by the agreement. The buy-sell agreement can control future transfers of the business and can have a direct impact on the owner’s overall business succession plan. For example, the agreement may require each owner to purchase the business interest of a deceased owner, or may require the business to redeem the deceased owner’s interest.
Buy-sell agreements may 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. If the buysell agreement doesn’t cover a particular event, there is potential for conflict and financial uncertainty if one should occur.
Rights versus Obligations
When a triggering event occurs, the agreement may require a mandatory buy out, give one party an option to purchase or sell, or give both parties options. Owners can be aware of the rights and obligations created by the agreement and confirm that they are appropriate given their business succession goals. Buy-sell agreements should be drafted with the advice of your legal counsel.
A closely held business can be one of the most difficult assets on which to place a proper valuation. Even more difficult can be trying to set an appropriate value for that business at some unknown point in the future.
The buy-sell agreement may contain a method for valuing the business that all parties not only agree on, but fully understand.
Some agreements state a specific value and require all owners to agree to a new value annually. Another option may be to provide a stated formula (for example, four times earnings before interests, taxation, depreciation, and amortization), or to leave the valuation up to appraisers who are approved by the owners. Again, the goal is to reduce the potential for conflict and to allow for the owner’s business succession goals to be accomplished.
The specific timing and details of the actual buy out can greatly affect the success and efficiency of the transfer of ownership. The needs and goals of both the potential buyer and the seller can be taken into consideration. For example, spreading out the purchase price over a period of years versus requiring a lump sum payment may help to avoid cash-flow issues for the buyer. Sellers, on the other hand, may want to keep the installment period shorter to minimize the risk of not getting paid and to expedite their liquidity event. Interest rates on any installment sale can be tied to an index (such as the prime rate) rather than setting a fixed rate that may be out of date when a triggering event occurs.
The transition of a business ownership interest may be a sensitive time in its lifecycle, and is likely a bad time for the business to have overly burdensome strains on cash flow. Buy-sell agreements can plan for liquidity demands placed on owners or the business itself. To avoid such pressures, triggering events such as death and disability may be funded with insurance contracts, while other triggering events may be funded with the establishment of side fund investments.
The purchase and sale of a business should be designed to be as tax efficient as possible for all parties involved. Buy-sell agreements can be drafted with the advice of your tax professional.
Separate Business Properties
Buy-sell agreements can identify all assets related to the business and provide the appropriate terms for each. These may include land that is separate from buildings, intellectual property, client lists, equipment, and life insurance policies covering the lives of owners or key employees. Any long-term goals for specific assets might also be addressed in this agreement.
Exceptions for Family
You may consider the impact of overly restrictive language that prohibits the transfer/gift of your interest to future generations. A blanket statement that restricts all transfers without the approval of other owners may create conflict when a business owner later desires to bring a child or grandchild into the business as an owner, either during the owner’s life or upon death.
There can be fundamental tensions that arise when individuals who are not involved in the business obtain an ownership interest. As owners, they may have access to company financials, the right to dissent to certain business transactions, the right to a buy out of their interests, and even a right to demand that the business be judicially dissolved. These rights can be taken into consideration before providing an individual who is not active in the business a right to purchase an ownership interest.
As your business grows, enters new markets, adds shareholders, or goes through any number of changes in the typical lifecycle of a business, your buy-sell agreement can be reviewed to determine whether it continues to be aligned with the goals of the business owners.
Buy-sell agreements can allow you to express your goals as to how your business interests should be transferred in the future while creating contractual limits intended to allow those goals to be met. Owners may consider a comprehensive exploration of the points discussed above when crafting a buy-sell agreement to help set a plan that can avoid conflict between owners and family members and create an efficient transition.
PNC does not provide legal and tax advice—consult with your legal and tax advisors regarding your individual situation.