5 Big Questions (and Possible Answers) to Consider Before Entering into a Buy-Sell Agreement
1. What type of arrangement is best? Traditionally, there are three basic types of “buy-sell” agreements – a redemption arrangement, a cross purchase arrangement and a hybrid arrangement.
- Redemption—A redemption arrangement is one in which the business agrees to purchase the business interest from an interest holder (e.g., shareholder) upon some triggering event (more on that later). It is easy to administer and simple to understand—and for that reason, it is often the most common form selected by a business. The business controls the funding and purchases (redeems) the interest of an owner. Life insurance can be used to fund the purchase price and is quite easy to obtain (as long as insurability is not a difficulty) — one policy is needed per interest holder. The ability of the remaining business owners to pay the purchase price for the business interest is irrelevant because the business will be making the payment. These are some of the strengths of the redemption arrangement. On the other hand, there are a number of weaknesses to a redemption arrangement. For example, in a redemption arrangement, the creditors of the business (if any) may be able to reach funds that the business has either set aside for the purchase or will obtain in a life insurance context, (i.e., before the funds reach the seller). Further, in a death context, the relatives of a deceased interest holder would not receive a step-up in basis which they would otherwise receive upon death, Rather, the remaining business owners would retain their original cost basis while their interest in the business increases (i.e., because the interest has been redeemed). There is also a greater potential for adverse tax treatment in a redemption situation (dividend treatment, alternative minimum tax, accumulated earnings tax, etc.).
- Cross purchase—In a cross purchase arrangement, the owners themselves, rather than the business, agree to buy each other’s' business interest (e.g., shares in a corporation or membership interest in a limited liability company). Generally, each business owner enters into the cross purchase arrangement and either is obligated, or has an option, to purchase the shares of his fellow owners upon certain triggering events. One of the weaknesses with this type of an approach is that the individual owner(s) is responsible for paying the purchase price. For instance, do all of the business owners have the financial wherewithal to fund the purchase of an exiting owner’s business interest? In a life insurance context, a cross-purchase structure usually requires that each owner purchase a life insurance policy on the lives of the other owners. The insurance policies may have disparate premiums due to varying ages or insurability factors of the owners and can make the insurance arrangement quite complex to establish and maintain for a multiple-owner enterprise. The use of a trust, escrow or partnership to acquire and maintain the life insurance policies can help solve this problem. Despite the drawbacks, there are a number of strengths to the cross purchase arrangement which make it an attractive choice. For example, in the case of an owner’s death, the purchasing owners will likely maintain the stepped-up his basis for the business interest because it is usually purchased from the heirs or beneficiaries of a deceased owner (who themselves received the business interest at a stepped-up basis). This becomes very important if the business is an S corporation where losses can be deducted only to the extent that the shareholders have basis in their shares. It is also important if the owners ever desire to sell the business in that it can help to alleviate large gains caused by a low-basis/high-value situation. Also, the cross-purchase arrangement can help avoid problems with the alternative minimum tax and the accumulated earnings tax, because the life insurance proceeds are not paid to the business, and the business does not have to accumulate funds to make a purchase.
- Hybrid Method—A hybrid arrangement is one which combines features of the redemption and cross purchase approaches. This type of an arrangement provides that either the business or the owners will have the option or obligation to purchase an exiting business owner’s interest upon certain triggering events. The most preferred structure for a hybrid arrangement provides options rather than requirements to purchase. For example, a hybrid arrangement might provide owners with the option to buy the business interest and if they fail to exercise this right, only then will the business have the option to redeem the interest (or, vice versa, the business has the option to redeem, which if it forgoes, then the owners may purchase). If the business entity is a corporation, the owners will need to be mindful of several caveats and suggestions. The hybrid arrangement can be structured so that the corporation only redeems so much stock as may be eligible for sale or exchange treatment under IRC § 303, and the remaining stock is purchased by the other stockholders. Upon a shareholder’s death, this takes advantage of corporate funds to purchase some shares, while assuring the basis step-up for the remaining shares. Corporations also need to be careful not to create a structure that might result in a constructive dividend situation (for example, if a shareholder is required to purchase and does not follow through, a subsequent purchase by the business might be considered a constructive dividend).
2. What are the triggering events? A triggering event is any event that will cause a portion of the business to be sold. Usually this is an event that will cause a specific owner to sell his or her interest in the business. Triggering events can be used as guide posts for owners to think through the common reasons why an owner might leave and the problems that arise as a result. Some of the most common triggering events and follow-up questions are as follows:
- Retirement—As business owners approach retirement how will their interest be transferred. Will they be able to transfer it as part of a sale to a third party? Must they offer the interest to the other owners first (e.g., right of first refusal)? Can they transfer the interest to a trust for their children
- Death—If a business owner dies unexpectedly, it can often be disastrous to the business. Does the interest pass to his or her children or family—and, perhaps more importantly, do the remaining owners want these parties as new business partners? Will the remaining owners have the ability to purchase the interest? Will the step-up in basis be salvaged?
- Disability—Like death, disability often strikes when least expected. Will the disabled owner continue to receive profits? Will the disabled owner’s guardians have any say in the operations of the business? Can a disabled owner be bought out at fair market value?
Voluntary withdrawal—What if a business owner simply wants to leave the business or sell his or her interest? Must the owner first offer his or her interest to the remaining owners? What if the departing owner is essential to the business—should there be a financial penalty for leaving? What if the departing owner intends to join or start a new business that would be in competition with the existing business—should the buy-sell agreement contain a non-compete clause?
3. How will you determine the purchase price? When a triggering event occurs and a purchase is triggered, a good buy-sell agreement will address how the purchase price is determined in every situation. Here are a few approaches:
- Periodic Agreement of the Owners (Fixed Price)—The owners agree on an initial fixed price and then periodically adjust the price on a set schedule. Many family businesses use this approach despite the drawbacks because they prefer to set the price themselves on a periodic basis. One recommendation for this approach is to provide that any fixed price set more than 18 months prior to a triggering event should be ignored and an alternative method used instead for valuation. One drawback could be that the owners may not have the discipline to meet on a set basis to accomplish the task of setting the price. Also, because of differing motivations, the owners may not agree on the price to be set. If the price is old, it may not represent current values. Changes may have occurred after the price was set, such as lawsuits, unanticipated business opportunities, etc., which render the price meaningless.
- Formula Approach—A formula (usually related to book value and/or earnings) is used to compute the value of the company. For example, the formula might be a) the average of the net profits (defined in the buy-sell agreement) of the company for its last three fiscal years multiplied by three, or b) book value (book value may or may not correspond to actual value—some buy-sell agreements might use a formula that is two times book value). If book value is used, the buy-sell agreement can specify whether it is calculated on a cash, tax or accrual basis. Theoretically, the formula approach should be flexible and provide an accurate value as the business changes. The value should be able to be calculated with only minimal assistance from the business’s accountant without the need or cost of a full blown appraisal in future years. One drawback to this approach is that it often can be time consuming at the outset. The parties will need to agree upon the formula to be used as well as the methods to be used in making any adjustments that may be necessary. For example, adjustments to book value might be made by appraising depreciated assets, factoring in bad debts, using actual (rather than accounting) inventory and considering favorable lease terms. The owners will likely need to consult a valuation expert when creating a formula.
- Appraisal Approach—In this approach, the business hires an experienced appraiser to value the company at the time the buy-sell agreement is put in place. The buy-sell agreement can also provide that this same appraiser perform additional reappraisals. In future years upon a triggering event, the business can be appraised again—if owners cannot agree on an appraisal then multiple appraisals can be used to reach a value. By definition, an appraisal reaches a “fair” price with regard to a fair market value. The drawbacks of this approach include, among others, that the business owners often really have no say in the determination of the price, and the costs of obtaining an appraisal (both at the onset and at a triggering event). In addition, fair market value is not always the price that negotiating parties want to pay for various reasons and an appraisal may not always be time efficient.
4. How will you fund the purchase price? Let’s suppose you’ve made decisions regarding triggering events and purchase price—you will also have to decide how any required purchases will be made. If a triggering event occurs and a party must purchase another owner’s interest, will he or she have enough liquidity to make the purchase? If the triggering event is death, one common option business owners use is life insurance—this is very typical in both the redemption and cross-purchase methods. Of course, if a triggering event is something other than an owner’s death, then life insurance will not work. Many business owners will agree in advance on the use of promissory notes with the terms of the note set forth in the buy-sell agreement (term of the promissory note, interest percentage, payment, etc.). The parties might also require a down payment or a percentage of cash that is due at the time of the purchase. Likewise, if promissory notes are used, the buy-sell agreement might require acceleration of the note if the business performs well or the remaining owners sell.
5. What are the payment terms? As noted above, business owners can be creative in tailoring buy-sell agreements that meet their specific circumstances. If life insurance is used or the owners are very liquid, perhaps the entire purchase price will be due at closing. This might also be the case when a redemption arrangement is used—as long as the business has cash on hand, it may be able to fund the purchase redemption immediately. The parties might also agree to payments over a number a years—perhaps adjusting the years based on the circumstance (e.g., a longer more flexible payment schedule if someone departs voluntarily and a shorter payment schedule for disability or death). The parties can also tie payment terms to performance of the business or provide for balloon payments at certain future events or at the end of a certain period. Business owners can also craft creative language to provide claw-back of profits or accelerate payments should the remaining owners immediately sell the business after another owner exits.
As you can see, planning a buy-sell agreement involves examining the goals, values and expectations of a business and its owners. It’s not always an easy conversation, but it’s one worth having.