Buy-Sell Plans for Business Owners

Small businesses are often created in moments of inspiration, perspiration and desperation. About 75 percent of them leave the starting line with a roar only to sputter to a halt within three years. A few make it past this first marker, gain access to commercial credit, and use it to shift into a growth gear.

A tiny fraction of these growth companies attract private equity sufficient to buy out the founders and return a handsome profit to new management and the venture capitalists who believed in them. Even fewer remain in the hands of the original founders and their families until the helm is turned over to a new generation and the race begins again.

In the frenzy of getting the business up and running, organizational meetings with lawyers and accountants and bankers, and developing and marketing new products, planning for the future is often overlooked. But, whether the business is eventually sold to outsiders and perhaps taken public or becomes a multi-generational endeavor, one basic planning tool should not be overlooked.

The buy-sell plan assures the participants that business ownership will remain in the hands of current owners at least during the infancy and growth stages.

A buy-sell agreement is a legal document that restricts the disposition of privately held business interests, usually to existing owners, their families, or selected employees. The agreement specifies the events, such as an attractive offer from an outsider or the retirement, death or disability of an owner, that trigger its operation. The agreement also addresses the purchase price and terms for payment.

Although an agreement among existing owners for the purchase and sale of an owner’s business interest may be reached at any time, there are several benefits to entering into the agreement before a triggering event takes place.

· From the seller’s perspective, a willing buyer is identified well in advance. This is especially important for owners of minority interests for whom there is a limited market outside of other owners, management or younger-generation family members. From the buyers’ perspective, the contractual right to buy a deceased or retiring owner’s business interest assures retention of control.

· The sales price and terms are established while all parties are alive and active and have equal bargaining power. This relieves both buyer and seller from having to negotiate terms and price following the death, disability or retirement of an owner — a time when the seller or his/her heirs are at their most vulnerable and when the company may be struggling to maintain normal operations.

· The Internal Revenue Service generally accepts the purchase price in the agreement as the business value for estate-tax purposes, if:

Ø the agreement is at arm’s length;

Ø the agreement is bona fide; and

Ø the agreement is not a device for transferring value to one’s family members.

Since so many tax disputes involve valuation issues, the significance of this benefit should not be underestimated.

· Financing can be arranged in anticipation of the buyout. Retirement buyouts are often financed through a combination of seller financing, additional company debt and cash on hand. Death or disability buyouts are often financed in part or in whole with life or disability insurance.

Although there are hybrid agreements that represent variations on the theme, there are two basic types of buy-sell agreements: the cross-purchase plan and the entity plan.

Under a cross-purchase plan, the business owners enter into an agreement obligating a retiring or deceased owner to sell, put or first-offer his/her business interest to the surviving owners for an agreed price. Under a mandatory buy-sell, the affected owner must offer his/her business interest upon the occurrence of a triggering event and the surviving owners must buy it. If the agreement provides for a put, the affected owner may offer his/her interest to the survivors, who in that case must buy it. If the agreement provides for a right of first refusal, the affected shareholder must first offer his/her business interest to the survivors, who may accept or refuse the offer. If the offer is refused, the affected shareholder is free to sell his/her interest to an outsider.

Example: A, B and C own equal interests of E-Widget, Inc. The shareholders enter into an agreement to buy one another’s interest in the event of an offer from an outside party, death, disability or retirement. Specifically, upon the occurrence of any of these triggering events, A must first-offer his/her interest, valued at $3,333,333, to B and C. B and C each has the right to buy a percentage of A’s interest based on his/her pro rata interest in the business. Because B and C are equal owners, each is entitled to buy one-half of A’s interest for $1,666,667.

With an entity plan, the owners and the company itself enter into a written agreement obligating a retiring or deceased owner to sell, put or first-offer his/her business interest to the business itself for an agreed price.

Example: X, Y and Z own equal interests of Acme.com, Inc. They have valued the business at $10,000,000 and have entered into an agreement obligating the business to buy the interest of any partner who dies, is disabled or retires. Specifically, upon the occurrence of any of these triggering events, X must first-offer his/her interest, valued at $3,333,333, to Acme.com and the company has the right to buy X’s interest. Following the purchase, Y and Z each own a 50 percent interest in the business, as compared to the one-third interest they owned before the purchase.

A major consideration with the cross-purchase and entity plans is financing the purchase price. Business owners are typically limited to three options:

· accumulation of assets in stocks, bonds, mutual funds or other investment vehicles;

· borrowing, if additional credit is available over and above existing term loans and credit lines; or

· disability income or life insurance proceeds (in the event of a buyout at death or disability).

In general, a buy-sell agreement allows for a seamless transfer of a retiring or deceased owner’s business interest. This promotes continued harmony among the surviving owners and the departed owner’s family. Employees and creditors remain confident about the uninterrupted continuance of the business. Customers and suppliers remain comfortable about doing business with the company. For help in developing a buy-sell agreement, talk with your financial, tax and legal advisors.

Our firm does not provide tax or legal advice. Please consult with your tax advisor before taking any action that may have tax consequences.

Provided by courtesy of Aaron Jousan Johnson, Managing Director with JCAP Group in Darien, CT.

Our firm does not render legal, accounting or federal or state tax advice. Please consult your CPA or attorney on such matters.

The accuracy and completeness of this material are not guaranteed. The opinions expressed are those of the author(s) and are not necessarily those of JCAP Group, J. Capital, or its affiliates. The material is distributed solely for informational purposes with no fee and is not a solicitation of an offer to buy any security or instrument or to participate in any trading strategy.