1. The Sad Reality. Statistics suggest that less than half of all business owners plan ahead for critical events in the life cycle of their business (e.g., disputes among owners, death or disability of an owner, and purchase offers from third parties, to name a few). A buy-sell agreement is a contract among a company and its owners that provides an opportunity to plan ahead, promote continuity among ownership, and accomplish other important goals.
2. Basic Types of Buy-Sell Agreements. As a general matter, there are three basic types of buy-sell mechanisms:
- The Redemption Approach. A redemption agreement is a contract between each owner and the company in which the company agrees to buy back or redeem an owner’s interest in the company under certain circumstances.
- The Cross-Purchase Approach. A cross-purchase agreement is a contract among the owners in which they each agree to purchase another owner’s interest in the company under certain circumstances.
- The Hybrid Approach. This approach combines both redemption and cross-purchase features into the overall structure.
3. Promoting Fairness and Harmony Among Owners. A buy-sell agreement can reduce the likelihood of owner disputes ending up in court. The typical business relationship has a life span of approximately seven years, so it is good business practice to plan ahead for mechanisms that will fairly and efficiently wind down a business relationship. Business owners should never underestimate the exorbitant economic cost of litigation, as well as the psychological and emotional toll of being involved in a lawsuit against business partners. The best time to identify and address buy-sell issues is during the early stage of a business relationship when everyone has an optimistic and cooperative attitude.
4. Providing Liquidity. Ownership interests in a privately held company are illiquid securities. That is to say, there is no open market through which an owner can immediately sell his interest in the company. A buy-sell agreement, however, can create a market for what is otherwise an unmarketable asset.
5. Promoting Smooth Transitions. A buy-sell agreement can serve as a road map for a fair and efficient ownership transfer via an agreed-upon price (or mechanism for establishing a price) and set of closing procedures. These mechanisms can promote the long-term success of the company by proving clarity and structure during what might otherwise be a tumultuous time for the company and its owners (such as upon the death of a shareholder or when the company terminates the employment of an executive/shareholder).
6. Playing a Significant Role in Estate Planning. A buy-sell agreement can reduce the financial burden on the heirs of a deceased business owner (e.g., estate taxes and other expenses) by providing for a mandatory purchase of the decedent’s shares. This mechanism also serves to protect the surviving owners from suddenly being business partners with the decedent’s spouse or other heirs. A buy-sell agreement may also serve as evidence of valuation of the business for estate and gift tax purposes.
7. Solving Phantom Income Problems. Most buy-sell agreements involving pass-through entities–such as “S” corporations, limited liability companies, and partnerships– include language providing a mechanism requiring the company to make distributions sufficient to cover the income tax obligations of the owners stemming from their allocable shares of company income. Without such a contractual arrangement, company owners could find themselves owing income tax on income they never actually received. This is often referred to as the phantom income dilemma.
8. Preserving “S” Corporation Status. For companies organized and operated as “S” corporations, there are a variety of restrictions on ownership imposed by the Internal Revenue Code (e.g., limits on the number of shareholders, restrictions on who can own stock, and the “one class of stock” rule). A buy-sell agreement can include language restricting the shareholders from transferring their shares to an individual or entity that would be ineligible to own shares of an “S” corporation. The agreement can also set forth the mechanics for making certain elections available to “S” corporations and their shareholders with respect to income and loss allocations when a shareholder terminates his entire interest in the “S” corporation or the corporation ceases to be an “S” corporation.
9. Understand the Attorney’s Role. When utilizing the services of a business attorney for preparing a buy-sell agreement, be sure to understand who it is the attorney is representing—the company, some or all of the owners, or both. It is not unusual for one attorney to jointly represent both the owners and the company, but while that may seem like a cost-effective approach, the owners should understand there are conflicts inherent with such dual representation. Ideally, each party to the agreement would have his own legal counsel representing his individual interests.
10. Be Wary of Form Documents. An effective buy-sell agreement should be tailored to the specific objectives of the owners of the company. A “fill-in-the-blank” form printed off the Internet will generally prove to be of limited value in the long run. These agreements do not have to be complicated from a legal perspective, but they are vitally important from a business perspective and should be drafted with care.
For additional information, please e-mail or call Eric Perkins at [email protected] or (804) 205-5162