Blake Roe, CPA, Partner, Plante Moran
As a business owner, you spend a tremendous amount of time and energy building and growing your business. Strategy is a crucial area of focus, but one area that’s often overlooked is planning for an unforeseen event. For example, what would happen to your business — and your family — in the event of your premature death or disability? How can you ensure a successful ownership transition and protect your family in the event of such an occurrence? One way is to have a buy-sell agreement in place.
What is a buy-sell agreement?
A buy-sell agreement is a contract that formally documents the terms related to the transfer of ownership interests for a business. The document acts as a guide to answer the “who, what, where, when, and why” questions of transitioning ownership. Without it, the transfer may be based on more arbitrary terms and not reflective of your wishes, possibly leading to confusion for both the business and your family within the company.
When does it go into effect?
A buy-sell agreement becomes applicable upon certain “triggering events.” While every agreement varies, these events include death, disability, divorce, separation of employment, retirement, and exiting a business. A buy-sell agreement can also address transfers related to a third-party sale; however, it typically only lays the groundwork for the sale transaction.
Once a triggering event occurs, the buy-sell agreement defines the terms for the transfer of ownership interests, such as who is eligible to be an owner, what purchase price is used, and what is the timeline and method of payment.
Why are buy-sells important?
Without a buy-sell agreement, the transition of your business may not reflect your goals. A properly structured agreement will not only address your concerns, but will also allow time for planning and necessary adjustments, ensuring:
- The value of the business interest being transferred is accurately determined (a process or formula is often included in the agreement).
- The business is transitioned to the right people.
- Terms of the ownership transfer allow for the financial success of the company and do not cause cash flow or debt constraints.
- The business is able to continue operating and successfully transition, with minimal impact to employees or customers.
The buy-sell agreement not only affects the success of your business; it can also play a major role to your personal financial success. Businesses are often a major asset on an owner’s personal balance sheet, generating income and providing financial support. When a triggering event occurs, ownership can be transferred away from you, resulting in a substantial financial impact. If the event is sudden, such as an unforeseen death, income may no longer be available, greatly impacting the lifestyle and assets available to your family. Without proper planning, the results can be devastating.
Can you give an example of a buy-sell agreement in action?
Let’s say Lisa holds a 50 percent interest in a company. She passes away, and no buy-sell agreement exists. According to the terms of her estate documents, her spouse, Bob, steps in to act in the same capacity. Bob has never had any involvement in the business, but now, he has a controlling stake in the company. This concerns the remaining owner, Sarah, who wants to buy Bob’s interest. However, Lisa’s estate cannot come to an agreement with Sarah on the price and terms for a buyout. Bob feels the value is too low and needs more than the offer to maintain his current lifestyle. As a result of the discord, employees are concerned for their own positions and begin to leave for other employment. Performance of the business begins to decrease, and profitability of the company declines.
Now consider this example: Lisa passes away, but a buy-sell agreement does exist. According to the terms, Sarah purchases the ownership interest at a value that was agreed upon by all parties and determined prior to Lisa’s death. As a result of the agreement, Lisa was aware of the value and able to properly plan for her surviving family. The company was also able to plan properly for the payout of the purchase price and plan to pre-fund the payout amount. After the purchase is complete, Sarah continues to make decisions for the company, and there’s little to no interruption in its performance.
Three common mistakes made with buy-sell agreements:
- Owners allow the agreements to become stale
- The agreement does not include real estate
- The buy-sell is unfunded, or the funding isn’t structured properly
Overall, a buy-sell agreement is essential to a properly structured business succession plan. It provides a roadmap to guide not only your business, but also you and your family. When structured and executed properly, it can help to ensure your lasting legacy.