A chief concern of the owners of a closely held business is what would happen to the business if one of the owners could no longer continue. Surviving owners generally want to ensure a continuity of ownership and management without having the departing owner’s successor thrust upon them. Nor do they want to unduly compromise the liquidity needs of the business by funding a significant buyout. Disabled or deceased owners would want their families compensated fairly for their share of the business. A properly drafted buy-sell agreement can achieve all of these goals by:
- Providing that upon the occurrence of a specified “triggering event,” owners are guaranteed that their interest in the business will be purchased;
- Providing that the owner’s interest must be sold to the company, the remaining owners, or a combination of the two;
- Providing a mechanism whereby the purchase price may be determined by market conditions in existence upon the occurrence of the event;
- Providing a funding source, primarily through insurance policies, so that the liquidity needs of the business or its owners will not be onerous; and
- Establishing a valuation of a deceased owner’s interest in the business for estate tax purposes.
An integral part of any buy-sell agreement is to specify what type of situations will cause a mandatory or optional buyout of an owner’s interest by the other owners or the entity itself. The most common of these triggering events are described below.
Death or disability. This event is almost universally provided for in the buy-sell agreement. Terms of this buyout will include the determination of disability, the time for payment to the owner or the owner’s estate, whether the entity or the surviving shareholders have the obligation to purchase the interest, and whether a funding mechanism, such as life or disability insurance, should be maintained by the entity or the owners personally.
Desire to sell the interest to a third party.
The agreement should provide that the terms of the potential sale be presented to the other owners, and that they be given the option of:
- matching the offer made by the outsider;
- purchasing the shares in accordance with the valuation method and payment terms provided for within the agreement;
- having the entity repurchase the shares issued in accordance with the valuation method provided for within the agreement; or
- allowing the sale to be effectuated to the third party.
Retirement of an owner.
While a sale to a third party would provide the other owners an optional right to purchase the selling owner’s interest, an owner’s retirement will generally trigger a mandatory buyout. Of course, the conditions under which an owner may have the right to retire so that the remaining owners, or the entity, would be compelled to buy that owner out are often a point of negotiation. Once again, valuation methods and payment terms will be important issues, because there are no outside funding mechanisms, such as life or disability insurance, available to bear the cost.
Owner’s divorce or bankruptcy.
Either of these events can subject the business to interference from outsiders. To prevent this, the other owners should have the option to compel the affected owner to sell his shares to the remaining owners or the entity itself, in accordance with the payment terms and valuation methods (to be discussed later.)
The CPA Journal April 2006, Understanding Buy Sell Agreements, By Howard Davidoff