If your family business has or anticipates having more than one owner, you need a Buy‑Sell Agreement. A Buy-Sell Agreement governs the terms and conditions under which ownership interests in the enterprise may be transferred. It can take the form of a standalone Buy-Sell Agreement, a Shareholders’ Agreement, or detailed provisions within a limited liability company’s Operating Agreement or a partnership’s Partnership Agreement. Without a current, well-thought-out Buy-Sell Agreement, business and family relations could be in great jeopardy.
Done right, Buy-Sell Agreements provide a path for transitions of ownership that is orderly and predictable. Here are ten of the most common pitfalls under Buy-Sell Agreements:
- Lack of a Buy-Sell Agreement. An unfortunately large number of family enterprises simply do not have any written agreement governing the purchase and sale of ownership interests. This leaves everything to chance and the good graces of the current owners.
- An Outdated Buy-Sell Agreement. Just because you entered into a Buy-Sell Agreement when the business was formed or several years ago, don’t expect it to serve its purpose now and in the future. No family or family business is the same as it was five years ago. Business, economic and interpersonal relations have all changed. Don’t expect your agreement to automatically keep pace. Plan on undertaking periodic reviews of your agreement and expect to make changes to address new developments.
- One Size Does Not Fit All. The best Buy-Sell Agreements are carefully tailored to the business and its owners. Spend time discussing the unique features of your business and its owners with your legal counsel. Do not accept the first draft. Work through various scenarios with your lawyer, accountant, wealth manager and other advisors to guaranty proper results. This also allows for broad input from various angles and is a good test of whether the agreement is accurate, precise and understandable.
- Burdensome Transfer Restrictions. No one wants to be forced to be a co-owner with a competitor or someone he or she finds unacceptable. That is exactly what could happen if there are no restrictions on the transfer of ownership interests. But are the restrictions too burdensome? Do they cause unintended consequences? Often, families wish to retain ownership within familial blood lines by prohibiting transfers to spouses. This, however, prevents the owner from obtaining a marital deduction at death, thus accelerating the payment of estate tax which could have been delayed until the death of surviving spouse. One workaround is for the Buy-Sell Agreement to permit transfers to a QTIP trust for the benefit of the surviving spouse during his or her lifetime.
- Missing Trigger Events. “Trigger Events” are the factual events that give rise to the company’s and other owners’ rights or obligations to purchase ownership interests. Common trigger events are death, disability, retirement/termination, bankruptcy, divorce and an attempted impermissible transfer. Does your Buy-Sell Agreement cover all of these events? Are there other events that would be appropriate trigger events for your business?
- Death as a Trigger Event. Should the death of a family shareholder create an obligation to sell ownership interests back to the company or to other owners? That may make sense for the owner of a small interest, but should it apply if a major owner dies? Instead, should an owner be able to pass ownership to his or her heirs, thus preserving that particular family branch’s ownership interest in the enterprise?
- Divorce as a Trigger Event. No one wants to be forced to be a co-owner with the ex-spouse of a former owner, but that is exactly what could happen in a divorce proceeding. The award of an ownership interest to an ex-spouse is typically an event triggering the right or obligation of the company and/or its owners to acquire that ownership interest. Is this the correct result? Or should the divorced, former owner be given the first right to re-acquire his or her former ownership interest?
- No Path to Liquidity. What if a shareholder would like to reduce his or her ownership interest? Many Buy-Sell Agreements provide no clear path to accomplish this, leaving shareholders effectively “stuck” if a separate deal cannot be negotiated. Uncertainty in a family business does no one any good. Perhaps a better route is to spell out a path whereby owners may reduce their ownership interests over an extended period of time under clearly expressed terms and conditions.
- Valuation Surprises. Vague, confusing or outdated valuation processes create great risk of unpredictable and unfair valuation results. The approach to valuing ownership interests is key. Is it clear and precise? Does it provide a fair result? Buy-Sell Agreements typically use fixed prices, formulas or appraisals to establish a sales price. Often the approach chosen at the onset of the agreement no longer results in a fair and predictable valuation, given changes to the business and its ownership. Setting an initial value by appraisal and then providing for periodic appraisals may be the best approach. While this approach is not the cheapest one, it does ensure that all owners have greater clarity around what their ownership interests may be worth.
- Unrealistic Payment Terms. Does the agreement require payment in full upon the occurrence of a trigger event, or does it allow for a down payment and payment over time? Given the varying size of ownership interests typically found in family-owned enterprises, are the payment terms workable for both the purchaser and the seller? The purchaser, whether it be the company or another owner, may have cash flow restraints. The seller will have his or her own cash needs, whether it be to fund tax payments or other obligations. These competing interests need to be carefully balanced to result in a “fair” outcome that does not jeopardize the financial existence of either one.
Now is a great time to review your Buy-Sell Agreement and to test it against present circumstances. We are certain that you will find ways to update and improve it. You and your family will be thankful when the time comes to apply its provisions for real.