Learn about the benefits of a buy sell agreement.
- A buy sell agreement is an invaluable tool to help preserve a business’ long-term viability.
- It helps to ensure that each departing owner receives a fair price for his interest, and establishes a funding source for the purchase of each departing owner’s interest.
- The agreement should be treated as a “living document” that will evolve as a business moves through its life cycle, and the owners’ personal circumstances change.
An owner’s interest in a closely-held business often constitutes a significant part of his overall wealth. For an owner who is concerned about preserving the value of this “business capital” for himself, and/or as a legacy for his family, a well drafted buy-sell agreement (BSA) by and among all of the owners is critically important.
From a business’ inception up until implementation of a final exit strategy by the continuing owners, a BSA is an essential tool to:
• Preserve the business’ long-term viability by preventing control from passing to unwelcome and potentially disruptive parties
• Ensure that each departing owner (or his or her estate) receives a fair price for his or her interest
• Establish a funding source for the purchase of each departing owner’s interest
Primary benefits of a buy sell agreement
Buy sell agreements have many benefits, with the most critical being to help current owners maintain control and to preserve the marketability of ownership interests. Maintaining control by current owners Over the long term, one of the greatest threats to preserving the viability of a closely-held entity is the risk of ownership interests passing to outsiders who will disrupt the smooth operation of the business. For example, the children of a deceased owner may acquire an ownership interest through inheritance, but elect not to take an active role in the business. This could lead to clashes between the children and the existing active owners on issues where their respective interests are not aligned—such as whether to distribute or reinvest profits. Under another possible scenario, the former spouse of an owner might acquire an ownership interest through a divorce proceeding, creating an uncomfortable and potentially unworkable operating environment for the existing owners.
In some cases, unrestricted transfers of ownership interests create legal and tax problems for the business. Certain types of entities, such as S Corporations and some professional services businesses, are required to limit their owners to enumerated permissible parties. In these situations, the transfer of an ownership interest to a prohibited party can result in adverse legal and/or tax consequences.
A buy sell agreement can mitigate the risk of these adverse outcomes by placing restrictions on transfers of ownership interests. To the extent possible, the restrictions should be structured in a thoughtful manner and accommodate an owner’s desire to transfer ownership interests under his estate plan—as long as such transfers are not expected to disrupt the operation of the business. In these cases the buy sell agreement can identify and exclude transfers that are part of the owner’s estate plan from the scope of the restrictions.
The restrictions on transfers typically take the form of “rights of first refusal” given to the business, or the current owners, to purchase the interest of a withdrawing or deceased owner, at a price established under the agreement. Rights of first refusal may be allocated among current owners either equally or on a pro-rata basis, or tailored to specific situations.
Where possible, an owner’s purchase rights should dovetail with his individual estate planning goals. For example, if the owner’s estate planning goals include transferring ownership interests to younger family members who are active in the business, it may be advantageous to reduce or eliminate his purchase rights in favor of expanded rights for the younger family members. In other instances, where a family’s collective ownership interest is spread across different family
members, it may be appropriate to allocate purchase rights in a way that maintains that family’s total ownership interest as family members die or withdraw.
While maintaining control of the business is the most direct benefit of granting rights of first refusal to the current owners, these rights also carry indirect planning benefits for the owners. They make it possible for an owner to anticipate the cost of buying out co-owners’ interests, and to develop a plan for funding the purchase in advance. Additionally, they allow an owner to anticipate the value of his ownership interest for estate tax purposes, which facilitates effective estate planning.
In some cases, the restrictions enable an owner to claim a valuation discount for his ownership interest based on lack of marketability, and thereby reduce gift and/or estate taxes upon transfers of the interests to family members. For owners who anticipate having a taxable estate, valuation discounts based on lack of marketability represent a compelling opportunity for tax savings on transfers to family members.
Preserving marketability of ownership interests
Another benefit of a buy sell agreement is that it can create a market for the ownership interest of a deceased or withdrawing owner where none may otherwise exist. This is accomplished by imposing a mandatory purchase obligation on the business, or remaining owners, to buy the interest at a price established under the agreement. In financial terms, this is analogous to granting a “put” option to the withdrawing owner, entitling him to sell his interest at a specified price.
For an owner who anticipates selling his interest at the earlier of his death or retirement, the benefits of such a mandatory purchase obligation are considerable. It permits the owner to negotiate the price that will be paid to him on his retirement, or to his estate following his death, well in advance and without unfair pressure. Absent such a provision, the estate of the deceased owner could be forced to either negotiate a sale from a position of weakness, or postpone any sale and risk a liquidity crisis when estate taxes become due and/or his surviving family members require funds for their support.
Identifying and understanding the potential benefits of a well-crafted buy sell agreement is a critically important first step in evaluating and/or designing an agreement. The next step is selecting the optimal type of agreement and the most advantageous method to fund the purchases.
Agreement types and funding methods
Buy sell agreements generally fall under one of the following two types, depending on who has the right, and/or obligation to buy a withdrawing owner’s interest under the agreement:
• Cross-purchase agreement: the remaining owners are the designated buyers
• Redemption agreement: the business is the designated buyer
When designing a buy sell agreement, the owners should consider not only what type of agreement to use—i.e., who should be the designated buyers—but also how the buyers will fund the purchase. Under both types of agreements, the buyer may purchase a withdrawing owner’s interest out of his available assets or with borrowed funds. For purchases of a deceased owner’s interest, buyers often use life insurance as a source of funding. This is particularly appropriate where it is uncertain whether the buyer will have sufficient funds to purchase a deceased owner’s interest. By procuring insurance coverage in advance, the buyer avoids a potential funding crisis at the time of purchase. Under this approach, the buyer takes out life insurance on each owner, and upon the death of an owner uses the proceeds to purchase the deceased owner’s interest. Permanent life insurance is advisable since it is usually difficult to predict an owner’s life expectancy, but term insurance may be appropriate in some cases. Owners should consult with their insurance advisors regarding the most appropriate type of coverage for this purpose.
In some cases, multiple funding sources may be needed in order to purchase a withdrawing owner’s interest. For example, the cost of insurance to cover the entire purchase price may be prohibitive where the business is large, and the value of the withdrawing owner’s interest is correspondingly high. In that instance, the buyer may be forced to supplement insurance coverage with bank financing or other capital raising strategies, as available, in order to cover the full buy-out amount.
It’s important for an owner to consult with his advisors to determine the type of buy sell agreement and funding option that is most advantageous for his particular situation.
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