Tuesday, April 10, 2012

The Buy-Sell Agreement is Essential for All Closely Held Businesses with Multiple Owners

If you own a piece of a business and have one or more partners, it is essential that the partners enter into a Buy-Sell Agreement.  The Buy-Sell Agreement is intended to address what happens in the unfortunate event of the demise or disability of you or one of your partners as well as other events resulting in the departure of an owner.  If you view the Buy-Sell as unimportant because you have an excellent relationship with your other partners, consider the nightmare scenario that one of the owners dies, and the only surviving heir is her dead-beat brother or her fifteen year old son.  Without a Buy-Sell Agreement in place, the result of taking on an unwanted partner could be devastating to the business operations; or the cost of buying out the new partner could increase dramatically, or obtaining the funds to pay for a buy out could put a substantial drain on the finances of the business.  A properly drafted Buy-Sell Agreement can eliminate these issues, ensuring the business continuity that is desired upon the disability, death of an owner or other triggering event.  Below is an overview of the essential components of a Buy-Sell Agreement. 

1.  What Events Should Trigger the Application of a Buy-Sell Agreement?  
The Buy-Sell Agreement addresses "what happens if ......" or, in other words, becomes essential upon the occurrence of a triggering event.  The key triggering events that should be included within the Buy-Sell include:

              (a) Disability or death of a partner:  It is very common to include death or disability of partner as an event requiring invocation of the Buy-Sell.  The Agreement should specify when a "disability" is deemed to have occurred.  In the event of disability or death, specify who is obligated to purchase the interests of the disabled/deceased partner -- is it the company itself or the surviving partners, and under what formula.  A major issue for all triggering events is how will the buy out payment be financed because the entity itself or the surviving members may not have the resources to pay the buy out price.  Therefore, the entity or the shareholders can anticipate the issue by purchasing life insurance.  Other issues, which apply to all triggering events, include how the purchase price is to be determined and timing for payment of the purchase price.

              (b)  Retirement of a Partner:  It is important to include retirement as an event triggering the Buy-Sell.  The Agreement should detail what constitutes legitimate retirement, in other words, when does an owner have a right to retire.  While price, payment terms, and timing must be detailed, owners need to be aware that the funding will need to come from the entity or other owners, as applicable, rather than relying on a life insurance policy.

             (c)  Divorce or bankruptcy of a partner:  Be sure to include divorce and bankruptcy as a triggering event because either of these can lead to an unwanted, or even unknown, person becoming an owner in the business.

             (d) Voluntary Decision of a Partner to Sell to a Third Party:  Provide a detailed procedure in the event an owner decides to offer her ownership to a third party.  The agreement should detail the mechanism, including the right to receive and match any third party offer; timing; the methodology for valuation of the interests; payment and closing terms; and rights of the parties in the event of the failure to close the transaction by the third party or the company/owners.    

             (e) Gift of Stock:  The Buy-Sell could allow a gift of stock upon consent of the corporation/shareholders or even a right without consent to certain defined persons (such as family members or a living trust), but in such instances the donee should be required to execute the Buy-Sell.

             (f) Pledge of Interests:  The Buy-Sell should address the right of an owner to pledge its shares, and if permissible, the obligation of a pledgee to comply with the Buy-Sell in the event of a default.

             (g) Material Breach of a Key Agreement:  One event that is often overlooked in a Buy-Sell is an involuntary termination of a partner.  Termination events include, for example, breach of a material term of an LLC operating agreement, breach of confidentiality, or a "for cause" event. 

2.  Valuation Methodology.   The biggest fight in any buy out of another owner is how to value the departing member's ownership interest since in a closely held company there is no public market to determine the value.  Valuation should be viewed in terms of three concepts:  (a) who is making the determination, (b) the procedure, and (c) what actual methodology should be employed?  As to whom is making the determination, consider whether an accountant or a person with expertise in valuation of your particular type of business makes sense.  When considering the procedure, issues include timing, will each party appoint the valuation expert, what if the valuations differ among the appointed experts, and how will the expenses of conducting the valuation be handled.  As to the methodology, consider whether it would make sense to choose a particular expert based on the nature of the business. 

The actual formula for the valuation varies as well, and the parties should consider identifying the applicable formula rather than leaving it up to the valuation experts:  book value, adjusted book value, a multiple of revenues or net income, or discounted cash flow.  The owners could actually fix a price in the Buy-Sell and update it as needed, but this requires a diligent effort to perform the annual or periodic update (so have a fall back formula in the event an update has not been performed in an unreasonably long time).  Be sure to consider all of these issues and then detail the valuation methodology in the Buy-Sell Agreement.

3.  Funding the Buy Out/Types of Agreements.  Where a buy out is triggered by death of a partner, regardless of whether the buy-out right is held by the entity or the other partners, funding of the purchase price can be arranged through a life insurance policy.

             (a) Entity as Purchaser/Entity Redemption.  The entity can purchase a life insurance policy which is distributed tax free to the entity upon the death of a partner, and the proceeds of which are then used to pay the estate of the deceased for the stock.  Understand, however, that there are several disadvantages to funding the buy out with a life insurance policy, including: 

                  (i) The proceeds and policy are not immune from the entity's creditors;

                  (ii) The basis in the stock of the surviving owners will differ depending on whether the entity is a corporation (no step up) or a pass-through, like an LLC (basis will increase in part);

                  (iii) There is a potential for the redemption to be viewed as a taxable dividend;

                  (iv) A majority owner could change the insurance policy beneficiaries; and

                  (v) The AMT (alternative minimum tax) may apply to the company's receipt of the insurance proceeds.

             (b) Cross Purchase Arrangement.  Under a Cross Purchase Arrangement, each owner purchases a policy on the life of the other owners, providing a tax free source of funding to pay for the decedent's stock upon his death.  Significantly, a cross purchase arrangement eliminates the above-mentioned disadvantages of the entity redemption arrangement.  However, disadvantages include:

                  (i)  The need for multiple policies if there are multiple owners, and premiums will vary depending on age and insurability of each partner;

                  (ii)  Transfer for Value Rule:  The transfer-for-value rule provides that, if a policy is sold by its owner after the policy is issued, the income tax exclusion for life insurance proceeds will be lost and the beneficiaries will pay income tax on the amount of the death benefit less the purchase price and premiums paid.  Thus, owners swapping policies to implement a cross purchase agreement results in a transfer for value.  For example, A might want to transfer his policy to B (and vice versa) to fund the cross-purchase obligation.  Upon A's death, B would collect the proceeds on A's life insurance and distribute them to A's estate in exchange for A's shares. Since there has been a transfer of the policies for value, B would be required to pay income tax on the insurance proceeds, less the amount subsequently paid in premiums.  Under an equity redemption arrangement, this problem would not exist.  Unlike with a corporation, notably partners in a LLC (taxed as a partnership) escape the effects the transfer for value rule.  Another possible work around is the appointment of a trustee to own the policies on each shareholder, otherwise known as a trusteed buy-sell, but there is a possibility that this could also be viewed as violative of the transfer for value rule.

          (c)  Hybrid Agreement.  Also referred to as the "wait and see" agreement, this situation gives the entity and its owners flexibility at the time of the triggering event to decide whether to exercise the buy-out right.  The entity may also purchase life insurance on the owners (or it may decide not to).  If the entity does not purchase the shares, the surviving owners can do so under a cross-purchase agreement (and also may purchase insurance for this purpose).

The Buy-Sell Agreement is a necessary document for any business with multiple owners, but it is also an essential tool for estate planning.  Without an agreement, you may find your new partner is that crazy brother of your old partner, and without a properly drafted Buy-Sell Agreement you may be exposed to unwanted tax liabilities.

Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.