Business Succession Planning

Small Business Buy-Sell Agreements

From do-it-yourself forms, to inexpensive online vendors, these days it is easy to incorporate your business. Like most things in life however, you get what you pay for. When reviewing client’s organizational documents, we often find that essential provisions are missing that are needed to assure a smooth transition when one owner of a company decides he or she wants out, gets divorced, or passes away. Unfortunately, this discovery comes after a problem arises and it is too late to take corrective action. In some instances, the failure to plan ahead for the departure of an owner places the company at risk of having to be liquidated.

To prevent this situation, it's important to do some basic business succession planning. This starts by having in place a solid agreement as to what will happen upon departure of a member. The agreement should cover the "8 D's" - Death, Divorce, Disability,Divestment, Disagreement, Default, Deadlock, and Determination of Value. If your current organizational documents do not adequately cover these possible situations, it's important to sit down with a legal professional sooner rather than later to put together a solid business succession plan. Almost all closely-held businesses, especially multi-owner corporations, limited liability companies, and partnerships, need a solid buy-sell agreement in place. Individually owned businesses can also benefit from the use of a buy-sell agreement. Buy-sell agreements are essential for the smooth transition of ownership upon the occurrence of any of the "8 D’s:"

1. Death of an owner. In the event of an owner's death, business can suffer a financial setback (key person loss), compounded if the surviving owners must take in a new partner such as the deceased owner's spouse. He or she may have very little knowledge of the business, yet expect a salary and profits from the business. Harmonious transition of the business can be accomplished with a buy-sell agreement fully funded with life insurance coverage.

2. Disability of a owner. While most buy-sells take into account death, many totally ignore what could be a more serious financial drain—disability. Often, disability is poorly defined and not funded or under-funded. A disabled owner would expect his/her salary to continue, as well as a share of profits. If the disability is extended, how long could the business keep paying? All of these decisions should be outlined in the agreement. It should be a business decision based on previously agreed-upon terms, not emotions.

3. Departure of an owner. When an owner leaves, whether for regular retirement or early voluntary retirement, his or her stock should be purchased. The purchase price can be the same as or less than the death price. A lower purchase price might be set for early termination. As for retirement planning, a life insurance policy can provide the death benefit and also be used as a retirement supplement.

4. Divorce of an owner. It's not unusual for a spouse to end up with half the stock of a closely-held business in event of a divorce. There should be a provision in the buy-sell to force the spouse to sell stock back to either the: (a) company; (b) original owner; or (c) other owners.

5. Deadlock. If equal owners come to a major disagreement, the business can become "deadlocked,” unable to further conduct normal operations. In this case, the business may have to be liquidated. This should be taken into consideration in the buy-sell agreement.

6. Disagreement among owners. If ownership is unequal and there is a major disagreement, a minority owner could be forced out of active employment. In that case, it would probably make sense to purchase his or her interest. This possibility should be taken care of in the agreement.

7. Default. In most closely-held companies, the individual owners must personally guarantee company loans from banks and/or contribute payments to the bank or business. In the buy-sell agreement, there should be a provision whereby if an owner defaults, a buyout is triggered for his or her interest.

8. Determination of value. The most important item in a buy-sell is the valuation ownership interest. No one wants to over-pay for a business interest. In addition, each owner wants to be sure he or she (or his or her family) receives fair value in the event of a living buyout or death. Appraisals may be viable and even required if family members are involved. Proper valuation also fixes the value in the deceased's estate for federal estate tax purposes. One stipulation is that the value must be fair market value at the time of the agreement. If appropriate life insurance is not purchased to fund the full value, then an installment purchase arrangement should be provided for the balance.

When buy-sells are drafted or reviewed, the above issues should be considered. It's far easier to make business decisions regarding these situations before they occur than to make emotional decisions after the fact.