6 Things To Know About Buy-Sell Agreements
How would you like your business partner’s ex-spouse to help run your company? Does it sound like fun to have a bank own part of your business should your co-founder file for personal bankruptcy?
Without a buy-sell agreement in place, business owners risk facing these scenarios and other situations that can disrupt the business and hurt its value.
Having a formal agreement can define a desired exit strategy and ownership succession plans, providing a roadmap in the event of a death, divorce or disability, says Rachel Flaskey, a senior manager in the valuation services practice of Baker Tilly, a top 15 accounting and advisory firm in the U.S.
“Those are all circumstances that can be planned for somewhat,” she says. “But you also have the unforeseen circumstances: an argument or the shareholders aren’t clicking anymore. Or maybe you want to allow future owners into the business.”
A buy-sell agreement allows entrepreneurs to know up front who can buy in to the business and how the process will work, and it provides opportunities to talk about possible scenarios rather than forcing owners into expensive litigation down the road.
“It’s one form of a business continuity tool,” Flaskey says.
Having a buy-sell agreement, however, is apparently not a high priority among many business owners. Nearly three out of four business owners lack documented succession plans (which can include buy-sell agreements) for senior roles. With the government estimating that nearly 52 percent of business owners are over the age of 50, that’s a lot of companies with the potential to be thrown into chaos and lost value upon the death of an owner.
Here are six things business owners should know about buy-sell agreements, according to Baker Tilly’s Flaskey:
They should be developed early. The time to create a buy-sell agreement is well before it is needed. As Flaskey says, “It’s a lot easier to get an agreement in place when everyone’s in agreement.” By the time circumstances warrant utilizing a buy-sell agreement, people could have other interests at play, making it more difficult to reach agreement on various items. And while it’s really never too early in a business’s life to develop a buy-sell agreement, keep in mind that business needs evolve as the business evolves and could warrant changes in certain agreement provisions over time.
Buy-sell agreements should include a business valuation clause. Some owners want to include a specific formula for valuing the business (e.g., “four times earnings before interest and taxes”), but the formula may not reflect the workings or true value of the business when it is applied, according to Flaskey. Business owners are better off with a clause in the agreement outlining that a business valuation expert will assess the appropriate ways to value the business.
They can reduce emotional impact. Developing the agreement before it is needed means emotions are less at play in big decisions. “People are focusing solely on the agreement rather their own individual interests,” Flaskey says. Involving an independent advisor to estimate the value or provide insight into the company every couple of years can reassure owners that they are on track and can reassure parties (including lenders) during a crisis that someone without a vested interest has reviewed the plan.
They should include ground rules. Buy-sell agreements should outline not only how price is determined, but also who can or can’t be a buyer and how a business sale will be funded. This is helpful in circumstances where owners want only certain family members to be able to buy out ownership and to control decisions. A clause outlining what may trigger the sale of the company can prevent having fiduciary agents (such as lenders) take control in the event of a personal bankruptcy by one owner. Outlining how any sale of ownership is to be funded (cash, debt, insurance proceeds, etc.) helps ensure proper planning of company liabilities, Flaskey says.
Valuation methods matter. A buy-sell agreement is where business owners have control over how simple or how complex they want to make the process of developing a business valuation, based on the company’s unique characteristics. It might make sense for a company that owns only real estate to get real estate appraisals and use those to develop an overall asset value. Companies with more complicated operations, however, might prefer that a price be developed using market-based, income-based or total-asset-based approaches.
Buy-sell agreements have tax implications. Uncle Sam always needs to be paid, Flaskey notes. “There are certain ways that a sale or buyback by the company can be structured to minimize taxes or to allow them to be paid over time,” she says. Without consideration of tax matters, an owner planning to fund his or her retirement by selling shares could wind up with drastically reduced proceeds.
Typically business owners involve a lawyer, their accountant and sometimes an outside valuation professional to walk through developing a buy-sell agreement. Flaskey says talking through what owners want to accomplish with the agreement is important. “Is it to avoid arguments, to maintain value, to provide an exit, to make sure that if somebody’s not really involved in the business anymore they’re not getting the benefits of other people’s work?” she asks. “The purpose behind it drives some of these other factors.”
For many businesses with $10 million or less in revenues, the market for selling the business is pretty small. Given the number of baby boomers nearing retirement, having a buy-sell agreement or other exit plan is really important, according to Flaskey.
“If you get to retirement and you can’t sell the business, what’s going to happen to it? You either need to be grooming management or one of your kids, you need to be thinking about selling to a key employee or converting to an employee-owned company,” she says. “There are a lot of business planning tools and a buy-sell agreement is just one of those.”
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