Most business owners sacrifice and sweat their way to success by focusing on making decisions that will move their businesses forward, but they neglect planning for eventualities that could erect insurmountable obstacles or even incapacitate their business in an instant. Regardless of the way your business is organized – corporation, LLC, partnership, or sole proprietorship – if you own a privately held business, you need to plan for the continuation or transition of your business when you and your fellow owners face certain inevitable circumstances.
Succession planning may not be as complex as you think, especially compared to the decisions you have made building your business, but it is all too often pushed aside to be dealt with later. Unfortunately, in life and in business, you never know what is around the corner. Whether your business is just taking off or is steady and mature, the time for succession planning is now. One of the key instruments to achieving your goals could be a buy-sell agreement.
A buy-sell agreement is one succession planning tool that owners of privately held businesses utilize to pre-determine what will happen when certain contingencies arise. Commonly, a buy-sell agreement will create a formal process to handle the death or disability of a business owner. It will also protect multiple owners when one owner’s interests may not coincide with the interests of other owners. For example, suppose one owner wants to resign, declare bankruptcy, or transfer his business interests to a third party. In some cases, multiple owners simply cannot agree on critical decisions, at which point agreeing on anything can become difficult, particularly a formula for buying out one party’s interest in the business. However, if a buy-sell agreement is in place, the owners can agree on a buyout formula before conflicts arise, and avoid deadlock among the parties when it does.
A far too common situation occurs when one business owner passes away, and his ownership share passes by succession to a spouse or children – people who may not have been groomed to step into the business. Decision-making will now be split between the other owners and one or more family members who have no substantive financial or operational knowledge of the business.
If you find yourself the remaining owner, you are now doing the job of two people, but only reaping the benefits of one. Further, the future success of your business may now depend on your former partner’s family members who have been thrust into the business unprepared. As a consequence, your long-term financial security may have been compromised.
If, based upon the above illustration, you had a buy-sell agreement, you and your partners could have designed a plan to avoid such a predicament. For example, you could have agreed to a buy-out price or calculated a formula to put a value on the shares held by each owner in your business, thereby providing for an efficient, predictable, and orderly transfer of business ownership and operations. If you are the surviving owner, you will have ensured a yourself a proportionate balance of decision-making authority, personal investment, and financial reward. In turn, you can rest assured that your family will receive a fair value for your shares when you leave the business, and your family will be free to focus on their own endeavors.
Alternately, you and your partners could have agreed to a leadership transition plan for the next generation of management. For example, you may have designated an experienced individual to take your place, or manage the business in the interim while your successor matures or trains for the role. Having a formal buy-sell agreement in place not only prepares you and your business for these contingencies, it drives you to evaluate and design plans that ensure the proper transition when the need arises.
These buy-sell agreements can have substantial costs at the time they are triggered. Because business owners may not have the capital to buy out the shares of their fellow owners or support a leadership transition, many purchase life and/or disability insurance to cover the costs. When a business has only a few owners who have agreed to purchase shares from one another in the event of loss, each owner may obtain insurance on each of his fellow owners individually and use the proceeds to buy out the departing owner’s shares. However, when a business has many owners, each may agree to sell her shares to the business in the event of loss. In this case, the business may obtain insurance on each owner, and then collect the proceeds to purchase the departing owner’s shares. In either event, having a plan in place will help you to establish the amount of coverage necessary and create an affordable mechanism to meet your succession goals.
It is important to point out that, while this discussion centers primarily on issues affecting your interests as an owner of a business, other related planning may be necessary to protect the business itself. What is commonly known as "key-man" life insurance is designed to compensate the business for its losses when someone critical to the business operations can no longer serve the business due to death or incapacity. With key-man life insurance, your business will be prepared to weather a devastating loss while becoming more secure and attractive to investors, vendors and customers.
If you have an ownership interest in a privately held business and are concerned about the succession of your business, a buy-sell agreement offers many benefits. It will preemptively protect you from unwanted actions by other owners, such as a sale of their interest to a third party without your approval, and prepare your business for transition when key owners or individuals are lost. Perhaps most importantly, it will instill a sense of certainty and confidence that your business and your family will be prepared and protected.
This article first appeared in Volume 3, Issue 2 of GE Capital’s Dealer Exclusive Newsletter in April, 2013.