Posted on February 13, 2012
A Buy-Sell Agreement (“BSA”) is a legally binding contract in the which the owners of a business establish when, to whom and at what price an owner can sell his or her interest in a business. BSA’s are a necessary element of any solid business plan in order to provide a smooth continuation of a business after the occurrence of a triggering event. BSA’s are also a valuable estate planning tool to provide liquidity needed for payment of a deceased owner’s estate taxes.
A BSA makes sense for any business entity with more than one owner, including corporations, partnerships and limited liability companies. A BSA is sometimes referred to as a “business will”, stock purchase agreement or shareholder agreement. In some instances, the terms of a buy-sell are included in an operating agreement for a limited liability company.
An integral part of any BSA is to specify what type of situations will cause a mandatory or optional buyout of an owner’s interest by the other owners or the business entity itself. Triggering events may include death, permanent disability, retirement, divorce, criminal conviction, termination of employment, desire to sell to a third party and bankruptcy.
It may be tempting to ignore funding when your BSA is being prepared, because the triggering events are perceived as being far off in the future. Without advance funding arrangements, there is a risk that the sale of your business interest could be delayed, or even worse, you or your estate may never get the money. The use of prearranged funding can help to eliminate any potential uncertainty that could come up at the time of the actual transaction. There are a variety of ways to fund a BSA, including but not limited to the following: cash, borrowing, installment sale, private annuity, life insurance, disability insurance, and self-cancelling installment note. What type of funding is most appropriate depends on certain factors such as the number of owners, type of BSA and the credit or cash available to a business. Ideally, the BSA should be fully funded from the beginning. In other words, the full purchase price should be covered under the funding arrangement; even partial funding is better than no funding. If it is impossible to fund the entire value of an owner’s interest, you can combine multiple methods, such as a cash down payment with installment payments to cover the balance. You can also combine the use of insurance with noninsurance methods. Overall, BSA’s should be funded by a method that will facilitate a smooth transfer of a business interest upon the occurrence of a triggering event. Ideally, parties to the BSA want to minimize the risk that the funding method will fail to provide the cash when needed.
Purchase Price/Valuation Methods
This may be an easy question in the early stages of your business. However, what happens as the business grows? The goal of a valuation method is to best estimate the business’s actual fair market value. The fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. In some instances, where less than the entire ownership interest is being acquired, there might be discounts to reflect the lack of control or lack of marketability. The most common way to obtain a proper valuation is to engage an independent professional accountant to determine the fair market value of the business. The fair market value is most often determined at the time immediately following the occurrence of the triggering event. This allows the business to be valued concurrent with the sale of the owner’s interest. In some instances, BSA’s provide for a predetermined price at the time the BSA is signed. This can be beneficial for purposes of funding for the BSA as all owners can adequately insure one another and the possibility that funds will not be available when needed is minimized. However, a disadvantage to this method is that the predetermined price of the business at the time the BSA is entered into may not be equal to the fair market value at the time of the triggering event.
Preparing the BSA
BSA’s are prepared by a business attorney, often in consultation with the business’s accountant and the owner’s financial planner. There are a number of ways a BSA can be structured taking into consideration the individual goals of the owners as well as tax consequences. The three most common ways a BSA can be structured are summarized as follows:
1. Redemption Agreement. Under this structure, the business entity is obligated to purchase the owner’s interest upon the occurrence of a triggering event. To minimize the impact this might have on the business’s liquidity needs, the business can purchase life insurance policies on each owner. The business names itself as the beneficiary of each policy, and the face amount of the policy will be equal to the agreed-upon or anticipated purchase price set forth in the BSA. The proceeds should be received by the entity free of ordinary income taxes, pursuant to Internal Revenue Code § 101.
2. Cross-Purchase Agreement. Under this structure, each surviving owner of a business becomes personally obligated to purchase the departing owner’s interest upon the occurrence of a triggering event. To provide the surviving owners with liquidity, each owner would own an insurance policy on the lives of the other respective owners. The proceeds of the life insurance policy would be received tax-free by the survivor and then used to purchase the deceased owner’s interest so that the survivor’s ownership interest remains the same in relation to the other surviving owners.
3. Wait-and-See Agreement. Under this structure, also known as a “hybrid agreement,” the entity and its owners have maximum flexibility upon the occurrence of the triggering event. Generally, the business has the initial option to purchase the shares from the departing owner in a business entity redemption format. The business may or may not carry life insurance on its owners. If the business fails to exercise its option, or purchases only part of the owner’s interest, then the surviving owners have an option to purchase the departing owner’s interest in a cross-purchase format. The owners may or may not carry insurance for this purpose. To the extent that this second option does not result in a complete purchase of the departing owner’s interest, then the entity must complete the purchase.
Updating the BSA
Business owners who have adopted a BSA have taken an important step in protecting their business, their families and themselves. Once signed, it needs to be kept up to date. Regular review of your BSA and the assets set aside to fund it is good preventative medicine. After a business lawyer prepares the BSA it is often “filed away” and most likely forgotten. Unfortunately, if the BSA is not regularly reviewed it may provide for issues down the road. A BSA, although based on information known when the agreement is first entered, becomes truly effective upon the occurrence of a triggering event. Without regular review and attention, the benefits the BSA was designed to deliver could be lost.
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