Buy-Sell Agreements: Continuity at the Top

Let’s say that you and your partners have a thriving business, call it WidgetAmerica LLC. Each of you owns a nice piece of that profitable company, making a good income and reinvesting in the business so that things continue to go well for years to come in the wild world of Widgets. Then something happens, you retire, or something catastrophic happens—car accident, a coma, death, jail time—something that will take you away from the company for good and all; something that will force you (or your heirs) and your partners to make some hard decisions.

 

The Buy-Sell Premise

One way to make this time of doubt and trouble easier is to institute a Buy-Sell Agreement. Essentially, this agreement stipulates that the other partners or co-owners are required to purchase your stake in the company should a “trigger event” take place, such as death, disability, retirement or some other stated event. Given that you will be paid a fair price for your part of WidgetAmerica—as spelled out by the Buy-Sell Agreement—this could mean you will have income for retirement or cash for your heirs.

 

Of course, if it is one of your partners who triggers the Agreement, then you will have an opportunity to increase your own stake in the widget business. You may even be able to take control of the company. Either way, you will be able to do it without any troublesome interference from surviving children or spouses. A Buy-Sell Agreement between partners keeps the business between the partners.

 

Structuring Your Buy-Sell Agreement

There are two ways of structuring your Buy-Sell Agreement, each with its own benefits and liabilities. The key to choosing one of these structures is to consider the tax consequences of each option.

 

Cross-Purchase Buy-Sell Agreements

The remaining owners are required to buy-out the departing owner’s interest in the company. This purchase gives the surviving partners 100% interest in the company. The partners also have a basis in the departing partner’s shares. This is called a basis “step-up” and will reduce their tax liability if they should sell those shares in the future.

 

Redemption Buy-Sell Agreements

In this type of Buy-Sell Agreement, the company itself, rather than the other partners, purchases the shares of the departing partner. When the company buys the stock instead of the other partners, that stock is not reissued, meaning that the remaining partners have the same 100% stake in the company that they would have had with a Cross-Purchase plan. The difference is that these partners have spent none of their own money and they don’t get the basis step-up tax benefit.

 

IRS Issues and the Right of Refusal

You cannot count on the IRS not taking an interest in this little transaction. If it is not done right, the money could be considered a kind of very taxable dividend. This is not inevitable, however. What you need is a solid valuation of the company and a plan that can anticipate tax difficulties and change the agreement on the fly to avoid them.

 

Evaluating the Company

The first thing you need to do is determine the actual fair market value of your business, the price at which the company would change hands between a willing buyer and a willing seller, both of whom have all the relevant facts and neither of whom are under any compulsion to complete the transaction. There are a few ways to do this:

  • Book Value . Also known as the net asset value method, this valuation method is based on the net worth (assets -- liabilities) of a business on a company’s books and records for accounting purposes. This is a fairly easy value to arrive at, however since it is based on historical cost principles, its accuracy can suffer. There are two variants on this method: Tangible book value, which is based only on tangible assets; and economic book value, which requires an appraiser to update the asset value to current market value.
  • Capitalization of Earnings . This method is based on an estimate of an acceptable rate of return on investment against the risk associated with that particular business. This estimated rate of return is then applied to the anticipated earnings stream of the business as based on the company’s average net earnings over the last few years. Potential buyers look for a rate of return well in excess of what they would expect from instruments like certificates of deposit or blue-chip stocks with rates of 20% or more being common.
  • Discounted Cash Flow . This method adjusts earnings for all noncash expenses (e.g. depreciation, amortization, gains and losses) and subtracts a reasonable amount of these expenses for future capital expenditures and liability payments to project the future net cash flow over a period of time. An acceptable purchase price is then determined using an estimated discount rate over the term and present-value concepts.
  • Sales-Multiple Valuation . This method is most commonly used to determine a fair market price for service businesses with few, if any, tangible assets. It works by attaching an industry-specific multiplier to an average stream of revenue over several years. These formulas, however, don’t take company-specific situations into account. Therefore, if the particular business being considered for purchase has a niche that distinguishes it from the industry average, the multipliers may not be appropriate. Variations of this technique may be based on multiples of gross margin or net profit.

 

The Right of First Refusal

Regardless of how you value the business, you still need a level of flexibility to be able to work out the best deal for all involved. Perhaps the easiest way to do that is by giving the remaining partners a right of first refusal. This gives the partners the right, but not the obligation, to purchase the departing partner’s share in the business. If they choose not to exercise that option, the company itself is obligated to purchase the shares.

 

Doing things this way gives the remaining partners a choice in the way they should proceed. They may make the purchase, take the basis step-up and enjoy the tax benefits; or they can let the company make the purchase, thus avoiding potential taxes on a constructive dividend. The point is that either way, there are tax issues. By including a right of first refusal in the Buy-Sell Agreement, the remaining partners will have a choice as to which tax issues they will have to face.

 

The Bottom Line

A carefully planned and well-executed Buy-Sell Agreement can ensure both continuity in ownership and management regardless of unforeseen circumstances. Setting one up, however, takes a great deal of attention and should not be done without sound legal assistance to draw up the agreement and the services of a good tax accountant to go through the tax ramifications that the partners and the business may face. Yes, it will cost a little money now, but a good Buy-Sell Agreement could save you much more down the line.