Many of our clients are business owners. Although these businesses tend to be successful, we have found that many of the owners do not have clearly defined succession plans. This month, we will look at one of the best ways to outline a succession plan, especially when partners or family members are involved in a business.
Tom and Julie met as project managers for a Fortune 500 company. After a couple of years of collaboration, they decided they could accomplish more and make more money in their own business. They’ve worked out most of the details about their individual roles, financial contributions, how they were going to raise capital, and even who else they might invite to join their venture. Their attorney advised that they also give some thought to a “buy-sell agreement” – a term that was new to both of them.
When they learned that it was an agreement for the eventual disposition of their business, they decided they had plenty of time to worry about that later – maybe 10 or 20 years from now. Fortunately, their attorney was able to explain why a buy-sell agreement should be part of the start-up documents, and they saw the wisdom of making it a priority.
A Buy-Sell Agreement is a written agreement among the owners of a business in which each owner agrees what will happen to their shares in the business upon the occurrence of a specified event (death, disability, termination of employment, etc.). Often the shareholders will agree that the shares will be sold to the surviving owners at a specific price. Each owner commits to buy the shares of their departing co-owner upon the occurrence of a specified event.
There are several reasons a good buy-sell agreement is important to you:
Buy-Sell Agreements can be funded (often with life insurance) or unfunded (usually with promises to pay). Funding a Buy-Sell Agreement with life insurance is the most practical method to fund a buy-sell as long as the owners are insurable. With life insurance, the heirs receive cash and walk away, and the surviving owner gets the deceased owner’s shares immediately. Unfunded Buy-Sell Agreements are usually better than no agreement, but the odds of the heirs ever getting paid are substantially reduced. Quite often the earnings of the company going forward are not sufficient to pay off the heirs.
There are three basic different types of buy-sell agreements:
How to Value the Company
The valuation section of a buy-sell agreement is very important because it defines how the value of the owner’s interest will be valued when there is a change in ownership. Changes will inevitably occur. Partners or shareholders of closely-held companies will decide to part voluntarily or an event such as death will trigger the buy-sell agreement. If this section of the agreement is skipped, it will lead to increased costs and time to determine the value of the interest at the time of the change.
The method of valuation should be clearly defined. A method should be selected that determines fair value at the time of the triggering event. Vague language for a formula that establishes a range of prices, rather than a firm price should be avoided. The reason is that two valuation professionals using vague language may calculate two very different values, either of which is within “the range.” If a company has only one owner, it’s up to that owner to find a successor and enter into a buy-sell agreement. Sometimes the successor will come from the next generation of the family.
When there is no related heir apparent and no co-owners, finding a successor can be difficult. A key employee might be designated. Or the owner of a successful medium-sized company or professional practice might actually acquire a smaller firm headed by a younger individual, in the hope that the prime mover behind the acquired entity will someday take over the larger firm. In any event, a buy-sell agreement should be in place between the current owner and the designated successor.