THE FIVE MOST IMPORTANT ISSUES TO CONSIDER IN A BUY-SELL AGREEMENT
Business owners who have other partners, members, or shareholders need to consider what will happen to their ownership interest on retirement, death, divorce, or permanent disability. The same is true for co-owners of major investment assets such as real estate held in a corporation, limited liability company, or partnership. A buy-sell agreement might well be the most important document that an owner will ever sign. It is an important part of a business owner’s estate plan because it often creates a flow of cash to the owner on retirement, death, or permanent disability. Each owner needs to consider five major issues before entering into a buy-sell agreement. PICK THE RIGHT BUYOUT TRIGGERS The typical events that trigger the obligation to sell or buy an ownership interest are known as buyout triggers. These typically are: Retirement Death Divorce Disability Breach of obligations under a major agreement with the entity, such as a failure to make an agreed-upon capital contribution. But in some situations, certain triggers may not be the right choice. If the entity owns an investment asset such as an apartment building that has a professional manager, the death, divorce, or disability of an owner may not be important to the ongoing operation of the asset. It might be just fine if the ownership interest passed to a surviving spouse or children at death. Another issue: what does the trigger trigger? A trigger normally triggers one of three rights: an option of a buying owner to buy out the selling owner’s interest an option of the selling owner to force the buying owner to buy out the interest of the selling owner, or a mutual obligation on both the buying owner to buy and the selling owner to sell the ownership interest. Of course, the owner who retires, becomes disabled, or dies wants to know that his or her ownership interest will be purchased. On the other hand, the potential buying shareholder wants to make sure that he or she is not forced to purchase an ownership interest that he or she cannot afford. PICK THE RIGHT BUYER For a key owner of an operating business, picking the right buyer is the most important decision the owner may ever make. The key owner must find a buyer who can successfully run that business in the future. If not, unless the purchase price can be funded with life insurance (which obviously works only on death) or by a loan (which is very hard to do for a small business), the business may not generate enough cash to fund the purchase of the interest. In a family-owned business, that right person to buy the interest may be a son or daughter. It may be an easy decision if one of your children is in the business and you know that child has what it takes to run the business. But this is not always the case, and it may be necessary to pick only a single child or two and not others to actually have the voting rights needed to make all important business decisions. If a business is a very significant asset in the owner’s estate, it may be necessary to transfer at death an equal interest in the business to each of the owner’s children. To make sure that children who will not have voting control of the business are not squeezed out by their siblings, their ownership interest can be in the form of a nonvoting preferred interest (similar to a long-term note), while the other children who will run the business receive a voting interest. Another approach is for the sibling or siblings who will run the business to buy out the interest of the other siblings. PICK THE RIGHT WAY TO SET THE PRICE Once the parties agree on the right triggers and buyout parties, a mechanism must be established to set the price of the ownership interest. It is, of course, very difficult to set a price today that will accurately reflect the value of an entity years off in the future. Buy-sell agreements solve this problem in numerous ways. One is to have the owners set the price each year. This method has a couple of flaws. One is that inevitably, the parties forget to set the price. Or, as often is the case, because of age or disease, it is apparent that one party will die, become disabled, or retire (and be a selling owner) before the other owners (who will be the buying owners). At that point, the selling owner is pushing for a high value while the buying owners want a low value. A more common approach is to determine the purchase price by an appraiser or by arbitration. The agreement should provide guidance to the appraiser or arbitrator whether the values should be discounted for lack of marketability (unlike Google stock, most ownership interests are not publicly traded, and the appraiser can determine an appropriate value discount) or, if applicable, discounted to reflect a noncontrolling minority interest (if the interest being sold is less than 51 percent). If the ownership interest will be sold between family members and an estate tax might be due, the discounts for minority interest and lack of marketability will reduce estate taxes, normally a positive result. It may not be a particularly positive result, however, if the non-owning sibling will be bought out at a discount or the surviving spouse is left without enough income to live on. PICK THE RIGHT BUYOUT TERMS Setting the right buyout terms is very important. If the price is too high or the terms are too onerous, a buying owner may just not be able to swing a buyout. This is not good news for the buying owner because he or she may end up defaulting on the payment obligation. On the other hand, it is not good for the selling owner either, who will lose the cash flow needed for retirement or to support a surviving spouse. Typically,…
