Buy-Sell Agreements and How to Fund Them

pen and paperwork

Buy-Sell Agreements are key documents that any business should have to establish the contractual obligations and rights of the owners at specific triggering events; e.g. death, divorce, bankruptcy, disability and/or retirement of an owner. Any good Buy-Sell agreement will have certain provisions such as establishing the priority for who can purchase an interest and a method to establish the purchase price. The point of such of an agreement is to establish the rules for fair play while everyone is getting along so that when the situation deteriorates, the separation or evolution of the business can be conducted in a manner that is orderly and objective so that the business has a chance of surviving the transition.

Careful attention should be paid to the type of valuation metric chosen for your specific agreement. Many of my clients choose to allow for a unanimous owner stipulation of the business value on an annual basis with the recommendation of the proper value from the business’ CPA or bookkeeper. If there is a year in which a stipulated value is not achieved for any reason, then the fair market value of the business as established by an independent business valuation controls. Still others design a metric specific to the type of business in which they are involved; possibly heavily weighting inventory values for a product business or cash flow for a professional service business. The key is to agree to a reasonable metric in advance that you would feel is comfortable and fair regardless if you are on the buying or selling end of the Buy-Sell transaction when a triggering event occurs.

There are three general forms of the Buy-Sell agreement available: 1) Redemption, 2) Cross Purchase, 3) Hybrid. The Redemption agreement is between the business entity itself and the shareholders. When a triggering event occurs, the business entity either has the right, or is obligated, to purchase the exiting owner’s interest. This can cause certain capital gains issues for the remaining owners; however, it creates a central method to fund and manage the transaction. The Cross-Purchase agreement is an agreement between the owners directly (instead of the between the owners and the business entity). This removes the potential capital gains issues inherent in the Redemption agreement; however, it creates a potential inequity in the funding of the agreement as various owners may either be less insurable or have lesser economic means. Finally, the Hybrid agreement is a combination of the two prior agreements. It can be structured to first allow the business entity the opportunity to redeem the interest for a certain period of time; and then if the business does not redeem the ownership, the other owners have the options to cross-purchase the interest. This method provides all involved with greater flexibility in the transaction to accommodate for changes in circumstances.

Funding Buy-Sell agreements can be done in a few specific ways; 1) use life insurance, 2) self-fund, 3) get financing, 4) incorporate an installment note provision. Generally, it is a good idea to build in a few of these methods into the agreement so that if one form of funding fails, there are fallback forms of funding available for the transaction. Regardless, it is not recommended to enter into a Buy-Sell Agreement without some form of funding mechanism built into the transaction. “Un-funded” Buy-Sell agreements are possibly just as dangerous, if not more dangerous, than having no Buy-Sell agreement in place at all. If your business has not contemplated its Buy-Sell agreement, please contact your JGB attorney to schedule an appointment to discuss and implement a solution.
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