Buy-sell agreements are important to every business owner and there is a high probability that, if not done right, they will lead to disputes and possible litigation.  Buy-sell agreements are agreements among business owners, or between the owners and the business itself, setting forth the price and terms of the purchase of an owner’s interest when certain trigger events occur.

After a trigger event occurs the parties have conflicting interests. So, buy-sell agreements should be created before any trigger event occurs.

Possible trigger events:

• Shareholder quits, is fired, retires, or dies
• Shareholder is disabled–disability must be defined
• Divorce
• Bankruptcy

Types of buy-sell agreements

There are two basic types of buy-sell agreements: redemption agreements and cross-purchase agreements. Under a redemption agreement, the company buys back a departing owner’s interest, while under a cross-purchase agreement the remaining owners purchase the interest. Typically, under either type of agreement, the purchase is funded by life insurance.

A disadvantage of cross-purchase agreements is that they require each owner buy life insurance on all of the other owners’ lives.  The number of life insurance policies can increase dramatically as the number of owners increases, and the policies are very difficult to administer. As a result, most buy-sell agreements are structured as redemption agreements, under which the business owns the policies.

There are several approaches to setting the purchase price, including:

• Fixed-price agreements — the price is agreed on before a trigger event and should be revised every year. But in most cases the owners fail to change the price over time. Consequently, the price may result in a bargain for either the buyer or the seller, depending on whether the value of the business increases or decreases over time. This often leads to costly litigation. What is needed is a methodology to fix the price at a later date if the value is no longer valid after the trigger event. These provisions often are not included in fixed-price agreements
• Formula agreements — e.g., five times earnings. In this case there may be one-time events that increase or decrease earnings and skew the value of the business. It is almost impossible to create a formula that can account for all types of future events, whether they occur inside or outside the company.
• Valuation process agreement. To avoid the problems with fixed-price and formula agreements, many companies adopt multiple appraiser agreements. The selling shareholder selects an appraiser and the buyer—usually the company—selects another appraiser. Typically, these appraisals set the price if the appraisals are within ten percent of each other. But that rarely happens. So, the two appraisers select a third appraiser to reconcile the difference. The agreement may provide for an average of the three appraisals, or the average of the third appraisal and the one closest to it, or the use of the third appraiser’s value. The standard of value must be agreed on and that is typically “fair market value,” which is the value at which a willing buyer and a willing seller, neither under any compulsion to act, would agree. There must also be agreement on how ownership percentage affects value. A minority interest may have a lower value than the selling owner’s pro-rata share of the value of the business.

Most problems can be avoided by having the parties select a single appraiser who, before any trigger event occurs, determines the value. The initial appraisal is a draft appraisal reviewed and agreed upon among the parties.  Because a trigger event has not occurred, agreement is more easily reached among the parties. This value is used until the same appraiser does a re-appraisal, performed periodically. When a trigger event occurs, one of the parties may request a re-appraisal. The parties know that the re-appraisal will reconcile the new value with the previous value based on the company’s performance and conditions in the industry.

Life Insurance

Life insurance can create complexities. A case study demonstrates: Assume a company purchases life insurance on, say, two equal owners.  Assume the value of the company is $8 million and each owner has a $4 million interest. Assume the life insurance is $6 million on each owner. Owner A dies and the company collects $6 million. At this point the company is worth $14 million and owner A’s estate has a $7 million dollar interest. The company pays A’s estate $6 million plus a note for $1 million. Now the remaining value of the company, all owned by owner B, is $7 million. This may seem fair, but if not agreed on in the buy-sell agreement, this arrangement can lead to a dispute and possibly litigation.

Keep in mind that death is only one of many trigger events and probably not the most common one. The payout when the departing owner does not die has to be funded by something other than life insurance, such as the issuance of a promissory note, a bank loan, or the accumulation of assets over time.

The foregoing discusses buy-sell agreements without including the effects of income taxes, yet income taxes can be a critical consideration. We urge you to contact us before finalizing a buy-sell agreement for a review of the possible income tax effects on the parties.