Buy-Sell Agreements Plan for Unexpected
Have you ever met a routinely pessimistic entrepreneur? Of course not. Only optimists start companies. Clients hiring a business lawyer almost never consider the prospect of a failed business, or a business absorbing an unexpected shock. Success handles itself. It is the job of the attorney to force entrepreneurs to confront potential failure and radical change. Consider:
- What happens if your partner dies or retires? Do you want to be in business with the widow/widower? Where are you going to get the money to buy out the decedent anyway?
- How are you going to handle things if your partner’s other deals bring him down? What if there is a bankruptcy?
- What if your partner quits and goes into business against you?
- What if your partner wants to sell his interest to a third party? Shouldn’t you have some say?
- How do you coordinate business arrangements with your estate plan? Should your family members involved in the business have a right to acquire your interest?
All of these issues need to be treated in a well-thought-out buy-sell agreement contained in the foundational documents of the business.
Buy-sell agreements can:
- Give the business entity the first option to acquire the shares of a deceased or disabled partner (or member of an LLC, or shareholder of a corporation).
- Give the entity an option to meet the price of a third party wanting to buy the interest of an existing partner.
- Give, if the entity declines to purchase, remaining shareholders options to purchase a decedent’s shares (or shares of a partner wanting to sell) in proportion to respective ownership interests.
- Define terms of termination for employee-shareholder and the consequences for such person’s shareholdings.
- Give, in the case of a deceased partner, the purchaser the right to finance acquired shares, for instance, paying 20% down, with a note at prime, plus 1% to 2% covering the balance.
- In the event of bankruptcy, give the company the right to a buy-out.
- In a venture capital deal, provide for “tag-along” and “drag-along” rights.
- Provide a noncompete clause for a departing partners.
- Allow business ownership to be held in living trusts for probate avoidance.
- Allow family members active in the business to inherit a business interest.
- Establish a valuation mechanism.
If a surviving partner has the right to purchase a deceased partner’s interest, how is the price to be determined? Some options:
- Have the accountant annually do a valuation that will apply for a death in that year.
- Use a “fair market value” metric, such as that of the IRS’s Rev. Proc. 59-60.
- Include an arbitration clause where the seller and buyer appoint arbitrators who are to select a third, with the three so chosen setting the value per the IRS metric.
- Require (or not) that the valuation procedure consider minority (or majority) discounts.
Life insurance can provide the liquidity to purchase the shares of a deceased partner. The company can:
- Purchase enough insurance on the shareholders to cover the downpayment.
- Or, shareholders can enter into cross-purchase agreements whereby they buy policies on each other’s lives.
Failure to plan for these business contingencies can result in litigation, financial distress and management paralysis. Well-thought-out buy-sell agreements set a road-map to deal with difficult contingencies and, thus, successfully plans for “failure.”
Copyright 2022 The Business Journal, Youngstown, Ohio.