As the excitement of the New Year begins to fade, small and closely-held businesses should examine the future of the business and its succession from current owners to those who will take the reins when owners depart.? There are several planning tools for business entities to prepare for the departure of the “old guard” and ensure that the business remains a viable operating entity.? One commonly used tool is the Buy-Sell Agreement.? Buy-sell agreements can also take various forms depending on the goals and unique situations of the company.
A buy-sell agreement establishes the means for an orderly and systematic continuation of a business entity.? Such agreements generally obligate a business or other co-owners in a business to buy all or a part of the ownership interest of a departing owner in the event of defined “triggering events” such as the death or disability of an owner, a planned owner’s retirement or the personal divorce or bankruptcy of an owner.? Buy-sell agreements also protect businesses from unexpected liquidity compromise in the event of a triggering event with requirements for funding mechanisms, such as insurance.? A carefully crafted buy-sell agreement will establish the means by which ownership interest is valued at the time of departure, such as certain market conditions, pre-set pricing, or some combination thereof as well as a valuation for purposes of estate tax.
The most common buy-sell agreements include Entity Redemption and Cross-Purchase agreements.? Under the entity redemption arrangement, the business entity itself is obligation to purchase the ownership interests of the departing owner.? Funding in this type of arrangement is often through the purchase of insurance policies on the owners wherein the business names itself as the beneficiary and upon the departure of the owner, the business uses the proceeds of the insurance policy to purchase the departing owner’s interest.? The face value of such policies would be equal to a previously agreed-upon purchase price set forth in the buy-sell agreement.? An entity redemption arrangement, however, does have disadvantages, including insurance policies and proceeds subject to the business’ creditors and potential substantial tax consequences.
With a cross-purchase, each surviving owner is personally obligated under the buy-sell agreement to purchase the departing owner’s interest.? Funding for this type of arrangement is generally through insurance policies each owner purchases on the lives of the other owners.? The proceeds of the insurance policy are out of the reach of the entity’s creditors although there can be personal tax consequences in certain circumstances, such as when insurance proceeds exceed the purchase price of an ownership interest where a market valuation may be used.
Often a combination of entity redemption and cross-purchase can be utilized such that the entity may purchase a portion of the departing owner’s interest and other owners and/or key employees can purchase remaining interest.
Some businesses have less formal agreements, including first-right of refusal, wherein the departing member can offer his or her interest for sale and the business or the other owners have an opportunity to match the asking price (or another offer from an outside source), in which case the departing owner is obligated to sell the interest to the business/individuals that match the price.
In addition to considering what type of a buy-sell agreement may be right for a particular entity’s needs and circumstances, there are several valuation methods which affect the process of succession.? Valuation methods are intended to predict the approximate actual fair market value of a business and ownership interest.? Some common methods include “Book Value” based on the net worth of an entity’s accounting records; the “Capitalization of Earnings” values a business by estimating an acceptable rate of return and apply that rate to projected business earnings; the “Discounted Cash Flow” accounts for various non-cash expenses and projected future capital expenditures to estimate future cash flow, then estimates a discount rate; and “Market Value” based on pre-determined market indices and measures to assess fair market value at the time of purchase.? Each valuation method has advantages and disadvantages.
SMART TIP:? Business Succession Planning is complex and should be part of a comprehensive estate and business plan developed after careful consideration and consulting with a team of professionals, including financial and legal advisors.