When you launched your business, you had a lot on your mind. One was probably not a buy-sell agreement.
However, if your company has more than one shareholder or partner, operating your business without a buy-sell agreement is risky. Despite good intentions and careful choices, bad things happen. A partner or shareholder’s illness or death, a shareholder dispute, bankruptcy, divorce, or addiction issue can shake the company. Even a planned retirement can throw a wrench into an otherwise smoothly running management scenario.
Cover the Bases
A buy-sell agreement, often incorporated into an operating agreement, dictates what will happen when a partner or shareholder leaves the company.
The agreement includes several legally binding provisions. For example, the agreement describes “triggering events,” or the circumstances under which it will go into force.
It dictates who can buy a departing owner’s shares, which may include third parties or be limited to other owners. It also dictates whether the corporation or partnership has a right of first refusal to the extent that transfers are allowable to third parties.
Having the agreement in place minimizes the possibility that shares can be sold or left to individuals or businesses that might create an undesirable or untenable partnership for the remaining shareholders.
The agreement also defines how the departing shareholder’s interest will be valued, including valuation method, purchase funding, and payment terms.
The valuation clause typically includes one of three types of pricing mechanisms: fixed price, formula, and valuation analysis. Most financial advisors agree that a fixed price is unworkable because it’s out of date as soon as it is created.
Formulas are more flexible and are designed to reflect current price based on inputs at the time of the triggering event. The challenge with this method is agreeing on the various inputs and nuances.
A valuation appears to be the “fairest” way, but like a formula, it involves inputs, the standard of value, discounts, valuation date, and appraiser. These issues must be discussed and agreed upon in advance.
Agree Now, Implement Later
Circumstances around a triggering event are typically emotional and involve one partner’s interests. For this reason, it’s important to decide on the buy-sell agreement early—when everyone is amicable and the business is running smoothly. An unemotional discussion is likely to result in a more reasonable arrangement.
A buy-sell agreement is a legal contract and is therefore drafted by an attorney. However, your CPA should be involved up front to help refine the valuation clause and review the document with your financial interests in mind.
Buy-sell agreements also have tax implications, so your CPA can advise you on structuring the sale or buyout to minimize tax liabilities.
If you don’t have a buy-sell agreement, now’s the time to make one. If you already have a buy-sell agreement, be sure to review and update it annually.