A fundamental part of any go-to-market plan for owners of a new business venture is the buy-sell agreement: a contract that offers them a method by which to gracefully exit the business or resolve disputes on mutually acceptable terms. Yet, say advisors interviewed by National Underwriter, few other business documents contain as many minefields.
“In almost any other negotiation, you know which side of the table you’re on,” says John Freiburger, a certified financial planner and principal of Partners Wealth Management, Naperville, Ill. “But when it comes to buy-sell agreements, you don’t know whether you’re negotiating for yourself or against yourself.”
The reason, he adds, is that several “triggering events” have to be factored into the buy-sell contract, any one of which can upend even the most successful business without careful consideration of its impact. Among them: the death, disability, divorce or retirement of one or more of the firm’s principals; or a forced departure because of disagreement among company owners.
Also key is how the buy-sell agreement will finance the buy-out of a departed principal’s interest in the firm. Generally, life insurance will serve as the chief funding vehicle, but in which situations would a particular life insurance contract be best? And how large should the policy’s face amount be?
The answers to these questions, sources say, will depend much on the owners’ corporate and personal planning objectives, their ability to fund out of cash flow, how the business is structured and valued upon the triggering event, and how payments to departing owners or their survivors will be made (i.e., as a lump sum and/or in installments).
Even a well-designed buy-sell can prove useless if it isn’t properly executed. Sandra Bring Heusinkveld, a chief life underwriter for Financial Planning Perspectives, Columbus, Ohio, says many doctors and lawyers are prone to giving away controlling interests in their practices as they add new partners. As a financial inducement to the new partners to join their companies, this strategy may be effective, but it ultimately could prove detrimental to the original owners.
“Once they give up control, these professionals leave themselves with little room to negotiate when it comes time to exit their practices,” says Heusinkveld. “The buy-sell is rendered unenforceable by virtue of what they’ve done. This speaks to the importance of keeping a team of advisors involved and working together.”
Problems respecting implementation are less likely to arise, she adds, if the buy-sell is framed from the get-go to account for all contingencies. For advisors, a key issue concerns the type of contract under which the business should operate. Often, the choice will be between 2 types: entity purchase (or stock-redemption) agreement; and the cross-purchase agreement.
In the first type, the business purchases (or redeems) the interest of a departing owner. After redemption, the ownership percentage of each of the remaining owners increases (e.g., from 25% to 33% in cases where the number of owners declines from 4 to 3.). Under a cross-purchase deal, the remaining co-owners buy out the interest of the deceased or departing owner.
How to decide between these contracts? A key consideration is the number of owners in the business. Advisors say they favor a cross-purchase agreement where there are only 2 or 3 owners, in part because of the “step-up in basis” that kicks in upon the death of a principal, the rule eliminating any taxable gain that remaining owners would otherwise be liable to pay. Cross-purchase agreements also generally receive more favorable treatment than do entity purchase agreements under IRC provisions respecting family attribution rules and the alternative minimum tax.
“Everything being equal, there are greater benefits for a client in a cross-purchase agreement than in a stock redemption agreement,” says Freiburger. “Yet, 90% of the buy-sells that I review are stock redemption agreements. That’s because the advisors who recommended them didn’t think though the process.”
Perhaps. But observers point out that cross-purchase agreements involving more than 3 owners make less sense for businesses because, as the number of owners rises, so does the agreement’s complexity and cost of administration. Whereas, for example, a business involving 5 owners would require 20 life insurance policies under a cross-purchase–each partner owning a policy on the lives of other 4–a stock redemption agreement would only require 5 policies. The business itself would own a policy on each of the owners.
Assuming the business owners aren’t sure whether a cross-purchase or entity-purchase is optimal, they can also elect a combination of the 2. This hybrid agreement provides a “wait-and-see” opportunity that permits remaining owners to individually purchase the equity interest of the deceased or departing owner or shift the burden of acquisition to the company.