Most all closely held businesses, especially multi-owner corporations and partnerships need to have a buy-sell agreement to facilitate a smooth transition of ownership upon the occurrence of several events, namely the “Eight D’s.”
We’ll discuss each one individually in the corporate context; however, most of the eight D’s would also apply to partnerships. In a single-owner business, the buyer could be key employee(s), a competitor, a supplier, or a customer.
The Eight D’s
1. Death of a shareholder–In the event of a death of an owner, the business can suffer a financial setback (key person loss). This problem can be compounded if the surviving shareholders have to take in a deceased owner’s spouse as a new partner.
He or she may have little knowledge of the business, yet expect a salary and profits from the business. A harmonious transition of the business can be accomplished with a buy-sell agreement fully funded with life insurance coverage.
2. Disability of a shareholder– While most buy-sells take into account death (though the agreement value may be low or underfunded), many totally ignore what could be a more serious financial drain: disability (the living death). Alternatively, disability may be poorly defined (if at all), not funded or underfunded.
A disabled shareholder would expect his or her salary to continue and would expect to get a share of profits. If the disability were extended, how long could the business keep paying? All of these issues should be addressed in the agreement. The buy-sell should be a business decision based on previously agreed-upon terms, not on emotions. And, of course, the agreement needs to be fully funded.
3. Departure of a shareholder–When a shareholder leaves the business, whether for regular retirement or early voluntary retirement, his or her business interest should be purchased. The purchase price can be the same as or less than the death price (it cannot be more).
A lower purchase price might be set for early termination. As for retirement planning, a life insurance policy can provide a death benefit. And cash values can be used as a retirement supplement.
4. Divorce of a shareholder–It would not be unusual for a spouse to end up with one half of the business interest of a closely-held business in the event of a divorce. There should thus be a provision in the buy-sell to force the spouse to sell stock back to: (a) the corporation; (b) the original shareholder; or (c) other shareholders. Again, the price cannot be higher than the death price.
5. Deadlock–If equal owners come to a major disagreement, the business can become “deadlocked,” unable to further conduct normal operations. In this case the business may have to be liquidated. This may have to be taken into consideration in the agreement.
6. Disagreement among owners–If ownership is unequal, and there is a major disagreement, a minority shareholder could be forced out of active employment. In that case, it would also probably make sense to purchase his or her interest. This possibility should be addressed in the agreement.
7. Default–In most closely-held corporations, the individual shareholders must personally guarantee corporate loans from banks and contribute payments to the bank or business. There should be a provision whereby if a shareholder defaults, a buyout would be triggered for his interest.
8. Determination of value–The most important item in a buy-sell is the valuation of the business interest. No one wants to over-pay for a business interest. In addition, each owner would want to be sure that he or she family members receive fair market value in the event of a living buyout or death. Appraisals may be viable and even required if family members are involved.
Another reason for proper valuation is to fix the value in the deceased’s estate for federal estate tax purposes. One of the stipulations is that the value must be fair market value at the time the agreement is entered into. If appropriate life insurance is not purchased to fund the full value, then an installment purchase arrangement should be provided for the balance.
A Good Checklist
When buy-sells are drafted or reviewed, perhaps the “Eight D’s” would make a good checklist for consideration. It’s far easier to make business decisions regarding these situations than it is to make emotional decisions after the event has taken place.
Paul A. Gydosh, Jr., CFP is a registered representative and investment advisor representative of Lincoln Financial Advisors Corp., Columbus, Ohio. You may e-mail him at [email protected].