Any business venture among two or more owners is much like a marriage; it is easy and painless to get into, but when the honeymoon is over, it can be very disruptive (and expensive) to untangle the interests of the business partners absent a prior written agreement which contemplates this very possibility. This is where a Buy-Sell Agreement can help.

A Buy-Sell Agreement is a specific type of business agreement which sets forth the terms by which business interests will be bought and sold upon the happening or occurrence of certain future events. For instance, a Buy-Sell Agreement can facilitate the transfer of an ownership interest under disruptive circumstances that may include an owner’s death, disability, termination of employment, desire to sell their interest to a third party, divorce, bankruptcy or other defined situation. Having an agreement in place gives an owner a ready market for his or her business interest, resolves estate liquidity issues, provides the framework for establishing the purchase price of the interest, and reduces the possibility of disputes. The following is a brief overview of some of the features and benefits provided by Buy-Sell Agreements.

Buy-Sell Agreement Format

Buy-Sell Agreements apply to all kinds of organizations including C-corporations, S-corporations, limited liability companies, joint ventures, limited partnerships, and general partnerships.

There are three fundamental formats for Buy-Sell Agreements: the redemption agreement, the cross-purchase agreement, and the hybrid agreement.

[1] Redemption Agreement. A redemption agreement is a contract between a business owner and the business entity in which they own an interest (the corporation, partnership, or LLC), by which the business owner agrees to offer their interest in the enterprise for sale to the enterprise itself, in certain specified situations. Such redemption agreements typically require that a business owner who wishes to sell their interest, must first offer the business entity the opportunity to purchase their interest in the company, at a price and on terms fixed in the agreement (or at a price and on terms similar to that offered by the outside buyer.) Similarly, the estate of a deceased owner will be required to offer the interest for sale to the business entity on terms and at a price set in the agreement.

[2] Cross-Purchase Agreement. A cross-purchase agreement is a contract between or among the business owners by which each owner agrees to offer their interest in the enterprise for sale to the other owners under certain specified situations. Similarly, the estate of a deceased business owner can be required to offer the ownership interest to the other business owners, on terms and at a price set in the agreement.

[3] Hybrid Agreement. A hybrid agreement is a contract between the entity (corporation, partnership, or limited liability company) and the business owners, and also between or among the business owners. In a hybrid agreement, each owner agrees to offer their interest in the entity for sale to the entity and to the other business owners upon the occurrence of certain triggering events. In some hybrid agreements, the business owner first offers to sell their interest to the entity and only offers it to the other owners if the entity declines to buy it. In other hybrid agreements, part of the business interests will be offered only to the entity, and part will be offered only to the other owners.

Events Triggering The Buy-Sell Obligation

Generally, in the context of any closely-held business (whether among related or unrelated owners), it is essential that the business owners provide for the orderly continuation, or, if appropriate, the dissolution of the business upon the occurrence of one of the following:

1. Death. Most Buy-Sell Agreements provide for a mandatory purchase of the ownership interest of a deceased business owner. This benefits the deceased owner’s estate, the business entity and the continuing business owners in several ways. The deceased business owner’s estate will benefit because the Buy-Sell Agreement will identify a specific purchaser of the ownership interest of the deceased owners, thus, a ready market will be created for the deceased owner’s estate. Moreover, because the Buy-Sell Agreement will mandate the purchase of the deceased owner’s interest, the Buy-Sell Agreement will provide the estate with liquidity to pay estate expenses (death taxes and administration expenses) and to support surviving heirs. From the perspective of the business entity and continuing business owners, a mandatory buy-out will allow the surviving business owners to avoid interference by the deceased business owner’s estate in the affairs of the business. Further, a mandatory buy-out may eliminate potential friction between the business, the surviving owners and the deceased owner’s estate since the purchase price and payment terms will be predetermined;

2. Disability. If the business owner is active in the business, an important issue to address is the ramifications if such person cannot or has diminished capacity to serve due to disability. It is critical that the owners carefully define the definition of “disability” that is to apply- whether permanent, temporary, partial or full. If disability insurance has been purchased to fund the arrangement, the definition of disability in the Buy-Sell Agreement should carefully track the insurance provisions, so that the same standards which apply for the payment of the policy benefits by the insurance company will also trigger the buy-sell provisions;

3. Termination of employment. If the business owner is also an employee, consideration should be given to the impact of such person no longer working for the company. Different rules may be desired, depending upon the reason for termination- for example, whether because of retirement, voluntary or involuntary termination or termination for cause;

4. Desire of business owner to sell to a third party. This often gives rise to a right of first refusal on the part of the business entity and/or the other business owners;

5. Divorce. This can prevent an ex-spouse from continuing to own an interest in the company;

6. Bankruptcy or other defined situation. Additional provisions can be implemented where creditors may be prevented from obtaining rights to ownership or control.

Establishing The Purchase Price

One of the most difficult decisions to reach in structuring a Buy-Sell Agreement is the method or formula for determining the purchase price of the interest to be bought or sold. There are several alternative valuation methods that are available:

1. Fixed Price Specified in the Agreement. The simplest valuation method is to simply provide for a buy-out price under the terms of the agreement. The problem with this method, of course, is that the fixed price should be adjusted to reflect increases or decreases in the value of the business. Therefore, most agreements incorporating a fixed price valuation will provide that the business owners shall periodically review and redetermine the purchase price, or the agreement can automatically update the purchase price with a cost of living adjustment. The new agreed upon purchase price will be incorporated into the Buy-Sell Agreement.

2. Book Value Method. Because most businesses prepare financial statements based upon historical cost information, a book value method for valuing business interests is another simple valuation method. However, because book values are based upon historical costs less depreciation, the book value of the business may not adequately reflect the true going concern value of the business. Thus, most agreements which incorporate a book value methodology will really use a “modified” book value method which will mandate that some business assets be valued at their fair market value.

3. Appraised Value. The Buy-Sell Agreement may simply provide that a purchase price will be determined by an independent appraiser. The agreement may specifically identify the appraiser or the method in which the appraiser will be selected. Attention should be given to the necessary qualifications of the selected appraisers and how the appraisal fee will be allocated among the business owners.

4. Fair Market Valuation. The principal advantage of the fair market value valuation method is that it avoids the problems associated with historical cost valuation. On the other hand, the use of the fair market value methodology will almost certainly necessitate the use of appraisers. Once again the agreement should specifically set forth the method for selecting the appraisers as well as how their fees will be allocated among the business owners.

5. Capitalization of Earnings Method. Under this valuation method, the value of the business is determined by multiplying the earnings of the business by a capitalization factor. The value may be determined using the business’ most recent earnings or by using a weighted average of several years’ earnings. The problem with using the capitalization of earnings model is that capitalization rates generally will vary among industries; thus, industry data should be examined to determine the appropriate capitalization factor.

Establishing Payment Terms & Methods Of Funding

The Buy-Sell Agreement should also specify how the purchase price will be paid. In some cases, the Buy-Sell Agreement will provide for the payment of the entire purchase price in cash. In some circumstances, however, the Buy-Sell Agreement will provide that the purchase price will be paid partly in cash and partly by the issuance of an installment promissory note. This will allow the purchasing entity to avoid having to go out and borrow substantial amounts of money to fund the buy-out. This is particularly important where it has not been possible to fund the buy-out with other means either because of uninsurability or because of insufficient opportunity to save sufficient assets for a buy-out.

In terms of funding the purchase price, in most cases, there are only three possible options:

1. Financing the Purchase Price. If the business or the continuing owners do not have sufficient cash to fund a buy-out, the purchasing parties may look for financing. Outside (third party) financing is often difficult to obtain since the business may have very little collateral to use as security for the debt. Furthermore, a third party lender may have deep reservations about the credit worthiness of the business after the occurrence of the death or withdrawal of one of the business owners. Absent third party lending, the owners may agree to finance the purchase price themselves by paying it over a number of years with interest.

2. Use of a “Sinking Fund”. If the business owners plan well, they may be able to establish a sinking fund, or company savings, for an eventual buy-out. However, there are several potential difficulties with use of a sinking fund. First, there is always the risk of premature death, disability or other triggering event. Thus, the potential seller, as well as the potential buyer, may be disadvantaged by the use of a sinking fund. Second, the establishment of a sinking fund may be quite a drain on the cash flow of the business or its owners. Third, the use of a sinking fund may also trigger an unwanted accumulated earnings tax for C Corporations.

3. Use of Disability and Life Insurance. The use of disability and life insurance are the most popular funding mechanisms, except in those cases where the owners are not insurable.

The foregoing was a general overview of some of the benefits and features of Buy-Sell Agreements. Careful planning is required in negotiating and structuring the terms of a Buy-Sell Agreement, and you should make sure that you are working with an attorney that has much experience in this area when undergoing this process. Because the Buy-Sell Agreement is structured with an eye toward the future, many unintended income and estate tax results may occur without proper consideration.

Contact Todd M. Villarrubia at (504) 982-8207 if you wish to discuss establishing a Buy-Sell Agreement for your business.