Why Buy-sell Agreements are Important to a Family Business

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According to financial advisors, 65 percent of family businesses fail in the first generation and over 90 percent fail in the second.  Then the third generation is left to roll of their shirt sleeves and start all over.   The reason for this is because of human nature.  It seems that children enjoy the benefits of mom and dad’s success with no appreciation for the hard work they put in.  The kids generally lack the dedication, creativity, and vision to continue the business.  Failure to plan ahead for transitional life events such as death, disability, and divorce can cause both business and family problems. 

The buy-sell agreement is a competent preventative tool that will help preserve a family business.    The buy-sell agreement allows the owner to specify a plan of action when something like death, divorce, or a withdrawing partner threatens the business’ ownership or the ability to continue.  This agreement is usually part of the company’s operating agreement. 

This type of buy-sell agreement is not designed for the sale of the business but to designate how an owner’s shares are to be sold, what price and who can purchase them, when the person leaves the business. 

If you’re in business with your family or will inherit a business in co-ownership with your siblings, you need a buy-sell agreement.  Randy Fairfax a fee-only financial consultant says, “It’s quite important.  Because sometimes they don’t keep hugging each other.”  Even though buy-sell agreements aren’t all alike, they share the following features: 

A statement of purpose

This is where owners determine what is most important about their business.   Typically the purpose of the business is different for each generation.  The goal is to decide on a purpose for the business that everyone can agree with.  The majority of the buy-sell agreement will be linked to the purpose. 

Restrictions on ownership

Some families will elect to limit ownership or controlling stock to descendants of their bloodline only and exclude their spouses.  According to Steve Faulkner, JP Morgan’s national managing direct of asset management and valuation, it’s “not as cold as it sounds.”  He said, “It’s important to distinguish between participating owners, whose function is key to the health of the business, and non-participating family members who merely receive a share of the profits.  If one of the 50-percent owners dies or becomes incapacitated, that doesn’t mean that the spouse is then entitled to suddenly become an employee and draw that same salary.  By creating this buy-sell agreement, you’re actually protecting the non-participating spouse who otherwise could end up with a 50-percent interest in a company that doesn’t distribute much income and has lost its livelihood.” 

Fairfax is in agreement with this train of thought, where a spouse inherits ownership and the business is hurt.  He says, “Usually they are not involved with the day-to-day operations of the business, so it usually creates a negative.  The spouse has a lot of emotion and a lot of security needs that come from the business.  From a good planning standpoint, having them receive the stock probably in the long run leads to those failure rates in the first and second generation.”

By clearly stating who can and can’t sell or acquire stock, you’re protecting your company from being mismanaged by those who don’t have the intimate business skills needed.  In addition, it protects your business from claims by divorced spouses, step-children, and widowed in-laws. 

Trigger points

The trigger points that create liquidity for the company are:  death, disability, divorce, retirement, withdrawal, and even termination.  When one of these trigger points happens, someone is going to want cash in exchange for a piece of the business.  If you don’t plan properly for such events, the company is left with few options and none of them are good. 

Fairfax says, “It’s tragedy sometimes.  You now have a brother who is suddenly in partnership with two sisters-in-law and works his tail off.  He’s 73 years old, he has great buyers for this thing, and he still doesn’t have the ability to sell and has to keep working his tail off to support these two sisters-in-law who are now remarried.  It does not lead them to have great times together.  He keeps trying to persuade them to sell, but from their perspective, why should they?  They’ve got it made.”

A competent buy-sell agreement will ensure that the company has the first and best choice of options for each trigger point.  Some of these options will be discussed in buy out financing later.  Falkner says, “You design trigger points so that you can exit the business and have cash in what otherwise is a very liquid asset.”

Valuation

You need to agree before an event triggers a share buyout what method will be used to determine the equitable estimate of the business’ value.  A commonly used practice by closely held businesses is to re-evaluate the valuation method each year and agree to use it for the next 12 months.  Other companies bring in independent appraisers on both the buy and sell side and agree to split the difference.  Then there are those who use valuation formulas and factor in ratios of price to earnings or actual book value. 

Faulkner says, “Here’s where you’ve got to look at the objective of all this.  Is it to maintain the business within the family?  If so, you may not want to get the highest and best value because the business may not be able to pay the same price that a private equity fund or a strategic buyer could pay.”  In addition, the IRS will be very interested in your valuation method.  Under Treasury Regulations Subchapter B, Section 25.2701-1 and 25.2701-2, it’s very clear that the IRS will be watching the valuations of any family buy-sell agreement very closely. 

Buyout financing

A business can experience substantial strain on its reserves and be forced into unattractive options with a buyout.  This is why many family businesses will use life insurance to ensure control of the company upon death of the owner.  The value of an owner’s share determines the value of the life insurance policy.  The company takes out a policy for that amount on the owner and names the company as beneficiary so the company can fund the buyout upon death. 

What’s generally not considered in a buy-sell agreement is an owner’s likelihood of becoming incapacitated, short-term or long-term.  For this type of situation, a life insurance policy won’t help.  Fairfax says, “You’re in a very big Catch-22 morally, you don’t want to hurt your spouse or sibling, you all built this together, but practically the business can’t afford to keep paying him and get a person of his skills and abilities.  So the business is going to keep going down, which of course lowers his value, but you don’t have the cash flow to buy him out.  It can get to be a very ugly picture.” 

Disability insurance is a fundamental alternative for buyout financing.  You should establish a schedule of payments overtime instead of a lump-sum payout. 

Important addendums

Falkner’s expertise confirms that businesses overlook a few important addendums when they draft the buy-sell agreement – a non-compete clause and a look-back provision.  The non-compete will prevent a family member from taking his buyout and starting a competing business.  If family members were secretly conspiring to profit from your departure, a look-back clause will protect you.    He’s seen these things happen before. 

Falkner says, “One of three siblings left the business, they abided by all the discounts, and six months later, the other siblings sold the business at a high value where no discounts would have been applied.  So the question came up:  Was this contemplated at the time?  Was this fortuitous timing?  The skeptic in me says they probably knew of something on the horizon.” 

A buy-sell agreement, when correctly executed, can be a powerful management tool in addition to keeping peace in the family and in the boardroom.  One of Faulkner’s clients has a buy-sell which will distribute 30 percent of his stock as bonuses to his management team when he turns 65.  They were concerned that the company might fall in the hands of incompetent heirs. 

According to Falkner, when mom and dad are still working the business, or at transition with the successor siblings is the best time to create the buy-sell agreement.  He says, “Typically, it can be implemented at that earlier, transitional stage, it can have better outcomes.” 

You need to get professional advice from your accountant, attorney, and financial advisor before you agree to any buy-sell agreement. Have the tax considerations addressed upfront, as it’s just as valuable to your company as the buy-sell agreement is. 

Source: www.bankrate.com

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