Small businesses are often created in moments of inspiration, perspiration, and desperation. A significant number of them leave the starting line with a roar only to sputter to a halt soon after. A few make it past this first marker,
Small businesses are often created in moments of inspiration, perspiration, and desperation.
A significant number of them leave the starting line with a roar only to sputter to a halt soon after. A few make it past this first marker, gain access to commercial credit, and use it to shift into a growth gear.
A tiny fraction of these growth companies attract private equity sufficient to buy-out the founders and return a handsome profit to new management and the venture capitalists who believed in them.
A smaller fraction still remains in the hands of the original founders and their families until the finish line, where the driver’s seat is turned over to a new generation and the race begins again.
In the frenzy of getting the business up and running, in the whirl of organizational meetings with lawyers and accountants and bankers, and in the dizziness of new product development, planning for the future is often overlooked.
But, whether the business is one that is eventually sold to outsiders and perhaps taken public, or whether it is one that becomes a multi-generational endeavor, one basic planning tool should not be overlooked.
The buy-sell plan assures ownership remains in the hands of current business owners at least during the infancy and growth stages.
A “buy-sell” agreement is a legal document that restricts the disposition of privately-held business interests, usually among existing owners, their families, or selected employees.
The agreement sets forth the events, such as an attractive offer from an outsider or the retirement, death, or disability of an owner, that trigger its operation. The agreement also addresses the purchase price and terms for payment.
Although an agreement among existing owners for the purchase and sale of an owner’s business interest may be reached at any time, there are several benefits to entering into the agreement prior to the occurrence of a triggering event.
From the sellers perspective, a willing buyer is identified well in advance.
This is especially important for owners of minority interests for whom there is a limited market outside of other owners, management or younger-generation family members. From the buyers’ perspective, the contractual right to purchase a deceased or retiring owner’s business interest assures retention of control.
The sales price and terms are established while all parties are active and alive and possess equal bar-gaining power.
This relieves both buyer and seller from having to negotiate terms and price following death, disability or retirement of an owner, a time when the seller or his/her heirs are at their most vulnerable and when the company may be struggling to maintain normal operations.
The Internal Revenue Service generally accepts the purchase price in the agreement as the business value for estate tax purposes, if: the agreement is at arm’s length; the agreement is bona-fide; and the agreement is not a device for transferring value to one’s family members.
Given that so many tax disputes involve valuation issues, the significance of this benefit should not be underestimated.
Financing can be arranged in anticipation of the buy-out. Retirement buy-outs are often financed through a combination of seller-financing, additional company debt and cash on hand. Death or disability buy-outs are often financed in part or whole with life or disability insurance.
Although there are hybrid agreements that represent variations on the theme, there are two basic types of buy-sell agreements: the cross-purchase plan and the entity plan.
Under a cross-purchase plan, the business owners enter into an agreement obligating a retiring or deceased owner to sell, put or first-offer his/her business interest to the surviving owners for an agreed upon price.
Under a mandatory buy-sell, the affected owner must offer his/her business interest upon the occurrence of a triggering event and the surviving owners must purchase it.
If the agreement provides for a put, the affected owner may offer his/her interest to the survivors, who must purchase it if he/she does so.
If the agreement provides for a first right of refusal, the affected shareholder must first offer his/her business interest to the survivors, who may accept or refuse the offer.
If the offer is refused, the affected shareholder is free to sell his/her interest to an outsider.
Example A, B, and C each own equal interests of E-Widget, Inc.
The shareholders enter into an agreement to buy each other’s interest in the event of an offer from a third party, death, disability or retirement.
Specifically, upon the occurrence of any of these triggering events, A must first-offer his/her interest, valued at $3,333,333, to each of B and C. B and C each has the right to purchase a percentage of A’s interest based on his/her pro rata interest in the business.
Because B and C are equal owners, each is entitled to purchase one-half of A’s interest for $1,666,667.
With an entity plan, the owners and the company itself enter into a written agreement obligating a retiring or deceased owner to sell, put or first-offer, his/her business interest to the business itself for an agreed upon price.
Example X, Y, and Z each own equal interests of Acme.com, Inc.
They have valued the business at $10,000,000 and have entered into an agreement obligating the business to buy each other’s interest in the event of the death, disability or retirement.
Specifically, upon the occurrence of any of these triggering events, X must first-offer his/her interest, valued at $3,333,333, to Acme.com and the company has the right to purchase X’s interest. Following the purchase, Y and Z each own a 50 percent interest in the business, as compared to the 33 percent interest they owned prior to the purchase.
A major consideration with both the cross-purchase and entity plans is financing the purchase price.
Business owners are typically limited to three options: accumulation of assets in stocks, bonds, mutual funds, or other investment vehicles; borrowing, provided additional credit is available over and above existing term loans and credit lines; or disability income or life insurance proceeds (in the event of a buy-out at death or disability).
Overall, a buy-sell agreement allows for a seamless transfer of a retiring or deceased owner’s business interest.
This promotes continued harmony among the surviving owners and the departed owner’s family.
Employees and creditors remain confident about the uninterrupted continuance of the business. Customers and suppliers remain comfortable about doing business with the company.
