Table of Contents
1. INTRODUCTION. 1
2. WHAT ARE BUY-SELL AGREEMENTS? 1
3. WHY YOU NEED A BUY-SELL AGREEMENT. 2
4. I WANT TO SELL BUT MY PARTNER DOES NOT. WHO WINS? 2
5. CREATING A BUY-SELL AGREEMENT. 2
5.1 Planning. 3
5.2 Drafting. 3
5.3 Approval and Implementation. 4
6. WHAT EVENTS SHOULD BE COVERED IN A BUY-SELL AGREEMENT? 4
6.1 Types and Triggers Vary. 4
7. VALUATION. 6
7.1 Fair Market Value. 6
7.2 Fair Value. 7
7.3 Formula Pricing. 7
7.4 Book Value. 7
7.5 Value Based on Insurance Proceeds. 7
7.6 Periodic Review and Consensus. 7
8. WARNING: DO NOT GIVE OWNERS AN INCENTIVE TO SELL. 7
9. LIFE INSURANCE FUNDING. 8
9.1 Cost of Insurance Versus Other Funding. 8
9.2 Continuity. 9
9.3 Preserving Business Capital. 9
9.4 Key Executive Insurance. 9
9.5 Owners’ and Survivors’ Needs. 10
9.6 Uninsurability Problem. 10
9.7 Partnership Ownership of Policies. 11
9.8 Disability Insurance. 11
10. TAX PITFALLS. 11
10.1 IRC §302. 11
10.2 Constructive Dividends. 12
10.3 Estate and Gift Tax. 12
11. BUILD A GOOD TEAM. 13
11.1 Attorney. 13
11.2 CPA. 13
11.3 Insurance Agent. 13
11.4 Valuator. 13
12. PRACTICAL TIPS TO REMEMBER. 14
13. S CORPORATION. 14
14. CONCLUSION. 14
Buy-Sell Agreements let owners and a business, agree to the terms and conditions of a future sale to smooth the transfer of an ownership stake under certain triggering events. They also provide a framework for establishing the purchase price of a business interest when an owner leaves or dies.
By creating a Buy-Sell Agreement, the owners of a small, privately held business can be prepared when an owner wants to be bought out, or worse, dies, goes bankrupt, or gets divorced.
Buy-Sell Agreements are often overlooked by shareholders who have diligently filed their articles of incorporation and adopted their corporate bylaws. Without a Buy-Sell Agreement, however, if a shareholder wants to leave the company and be bought out, there is no contract that says whether the remaining shareholders or the business must buy him out, or for how much.
Typical Buy-Sell Agreements will specify the type of triggers that cause a mandatory or an optional buyout, a determination of the appropriate valuation date imposed by the agreement, the price, the payment terms of the buy-sell obligation, methods by which the agreement will be funded, noncompete agreements between the parties, as well, as transfers of an owner’s interests permitted and prohibited by the agreement.
All types of closely held businesses can use Buy-Sell Agreements. The two most common types, cross-purchase and redemption agreements, typically use insurance to fund the purchase of ownership interests.
To draft a Buy-Sell Agreement that satisfies all owners and precludes future conflict, the owners need to understand their goals, the transaction’s ramifications and their options. Each party has rights, obligations, tax considerations and financial consequences.
2. WHAT ARE BUY-SELL AGREEMENTS?
Contrary to popular belief, Buy-Sell Agreements do not have anything to do with buying and selling companies. Instead, they control when and how interests in a business can be bought and sold. Buy-Sell Agreements are also sometimes called shareholders’ agreements or stock agreements.
Typically, a Buy-Sell Agreement controls the following decisions:
• Whether a departing owner must be bought out;
• Who can buy a departing owner’s interest (this may include outsiders or be limited to other owners);
• What price will be paid for an owner’s interest in the business; and
• What other events will trigger a buyout.
Buy-Sell Agreements apply to all kinds of organizations including C corporations, S corporations, limited liability companies, joint ventures, limited partnerships and general partnerships. Depending on the nature and ownership of an entity, types and triggers will vary, but every effective agreement should anticipate funding, be kept up to date and provide for a procedure to determine the purchase price.
It may help to think of a Buy-Sell Agreement as a sort of “premarital agreement” between co-owners.
3. WHY YOU NEED A BUY-SELL AGREEMENT.
It is a huge mistake to ignore the fact that sooner or later your business will change. The odds are that one of your founding co-owners will want to leave the company (and take his investment with him) before the rest of the owners are ready to call it quits.
4. I WANT TO SELL BUT MY PARTNER DOES NOT. WHO WINS?
When one owner quits to move to another city or leaves to start another business, without an agreement, who decides whether the remaining owners have a right or obligation to buy out the departing owner, and for much? If you do not anticipate and plan for circumstances like these, you are risking serious personal and business discord — perhaps even court battles and the loss of your business with correspondingly substantial litigation fees and costs, anxiety and business interruptions.
In addition, a Buy-Sell Agreement puts limits on who can buy shares in the business. Otherwise, you could be forced to share control of the company with someone with whom you would rather not run a business.
5. CREATING A BUY-SELL AGREEMENT.
YAHNIAN LAW CORPORATION helps clients understand the details of these agreements. Where lack of an agreement or misunderstandings over the interpretation of its terms are the basis of owner disputes about the value of their respective stake in a company, YAHNIAN LAW CORPORATION can also help resolve disagreements and determine whether a party may be subject to a penalty.
To draft a Buy-Sell Agreement that satisfies all owners and precludes future conflict, the owners need to understand their goals, their options and a future transaction’s ramifications.
It is not necessary that the same agreement apply to all owners of an entity. YAHNIAN LAW CORPORATION can help clarify owners’ choices and facilitate discussion. One way to go about it is to gather all parties to the agreement and their advisers at a neutral, comfortable site. Discussion points the parties must resolve to plan, draft, and implement a Buy-Sell Agreement include, but are not limited to, the following:
(a) The definition of value the agreement will use. The options include using an objective formula such as multiple of earnings, multiple of revenue or multiple of book value. Some practitioners consider formulas objective (an advantage), but others say they may miss subjective factors associated with a business (a disadvantage);
(b) Whether to employ an independent business valuator. If yes, the parties must decide how to select the professionals, how many to use and how to reconcile differences in valuations. If a Buy-Sell Agreement directs the use of independent business valuators, the standard of value that appraisers use may be fair market value, fair value, investment value, intrinsic value or book value.
(c) Periodic agreement of the appropriate value by the owners. Buy-Sell Agreements with this provision will need to be modified at regular intervals. Resolve how often the contract should be updated, how those changes will be documented and what happens if the agreement is not updated. Owners should ensure that all changes to the agreement are documented and properly executed.
(d) The option to let the price and terms of an offer from a third party establish the price. The parties can decide to let a third party’s offer to purchase an interest in the entity set a price for the business interest.
(e) The option trigger events. See Section 6 below.
(f) Life insurance funding mechanisms. See Section 9 below.
Once the main points of the agreement have been discussed, and all, or most, of the issues have been resolved, YAHNIAN LAW CORPORATION can draft a Buy-Sell Agreement. The initial draft will then be sent to each owner, and each owner’s CPA and/or separate legal counsel, for review. Each owner will have the opportunity to review the initial draft and offer suggested changes. If necessary, the parties can meet again to resolve any differences.
5.3 Approval and Implementation.
When the Buy-Sell Agreement is acceptable to all parties, the parties can sign the agreement, and any needed additional documents, either at the same time or separately.
The implementation of the Buy-Sell Agreement is as important as its creation. The parties are now obligated to takes every action needed, including funding the agreement, giving necessary notices, and acting in good faith, to implement the agreement.
6. WHAT EVENTS SHOULD BE COVERED IN A BUY-SELL AGREEMENT?
Typically, the events that trigger the buyout of an owner’s interest are:
• The retirement or resignation of an owner;
• An attractive offer from an outsider to purchase an owner’s interest;
• A divorce settlement in which an owner’s ex-spouse stands to receive all or part of an owner’s interest;
• The foreclosure of a debt secured by an owner’s interest;
• The personal bankruptcy of an owner; or
• The disability, death, or incapacity of an owner.
6.1 Types and Triggers Vary.
Two common types of Buy-Sell Agreements (cross-purchase and redemption agreements) may use insurance to fund the purchase of ownership interests and are activated by a partner’s death or disability. A third type, considered a hybrid of these two, also is an option.
(a) Cross-Purchase Agreements.
Under a cross-purchase agreement, upon an owner’s demise, the remaining owners individually agree to redeem the business interest of the deceased. The most common way owners prepare for funding a purchase in the event of a death is to have each owner obtain life or disability insurance policies on the other owners in amounts sufficient to pay for the business interest.
The advantages of this type of agreement are that the surviving partners typically receive any life insurance proceeds tax-free. The proceeds of those life insurance policies are not includable in the decedent’s estate. The agreement may or may not be acceptable to the IRS as defining the fair market value of the decedent’s business interest for estate tax purposes. If it is, the estate or its beneficiaries will have no income tax on the purchase of the owner’s interest, as the basis of the interest will be equal to its sale price. However, an agreement that undervalues the business interest for estate tax purposes may be invalid.
The disadvantages of a cross-purchase agreement are that purchasing a life or disability insurance policy on the life of each of the other partners becomes increasingly complex to administer as the number of owners changes over time. A potentially disparate cost of life or disability insurance may exist among owners who are of different ages and health profiles (young partners may pay very high premiums to cover older, less healthy owners). If there is no insurance, the funding will come from the after tax income of the remaining owners. If a surviving owner must borrow to fund the buyout, the IRS may classify the interest paid on the borrowings as investment interest, delaying the deductibility of the amounts paid.
(b) Redemption Agreements.
Under a redemption agreement, the entity typically redeems the interest of the departing owner. It is responsible for financing the purchase, which may be funded by the immediate use of the business’s resources (such as corporate savings), a financing arrangement defined by the agreement, remaining owners’ personal savings or life or disability insurance on the life of the departing owner.
The advantages of this type of agreement are that the business is responsible for its funding. The Buy-Sell Agreement may define the fair market value of the decedent’s interest for estate tax purposes. If so, the estate or its beneficiaries will have no income tax on the purchase of the decedent’s interest, as the basis of the interest will be equal to its sale price. If the agreement is not fully funded and surviving owners borrow to fund the buyout, interest payments to the estate will be deductible on the entity’s tax return.
The disadvantages of this type of agreement are that if a corporate entity is the beneficiary of buyout insurance, the proceeds of the policy may be subject to the alternative minimum tax. A savings account within a corporation in anticipation of such an event may create accumulated earnings tax problems, and if the business is not a corporation, it may be difficult to save. In the event a divorce triggers the agreement, the respective ownership interest of the remaining owners will change. S corporations do not have such tax problems.
(c) Hybrid Agreement.
Also called the wait-and-see or combination agreement, this type of Buy-Sell Agreement is an amalgam of the two categories above. It usually gives the issuing business the first right of refusal to buy the ownership interest and other owners the second option to buy. This order of consideration is important. If a C corporation, with accumulated earnings and profits, assumes an owner’s obligation to purchase another’s stake in a business, the IRS may impute to the shareholder a constructive dividend (that is, reclassify it as a dividend distribution).
(d) Partnership Owned/Hybrids.
The owners of the company would enter into a separate partnership. The partnership would own the life insurance and have terms similar to a Buy-Sell Agreement. This structure would avoid many of the problems outlined above, and protect the policy and proceeds from corporate creditors.
There are a number of ways to value a business interest when drafting a Buy-Sell Agreement.
7.1 Fair Market Value.
Common avenues for establishing the value of an ownership interest include “Fair market value.” The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Under a fair market value standard, a 10% interest in a company valued at $100 might be worth $5 because of discounts for lack of control and lack of ready marketability.
7.2 Fair Value.
Fair value is typically defined by statute and case law in the state in which a company is organized and commonly is interpreted as what is fair or equitable. In some states this includes discounts for lack of control or marketability and in others it does not. In states in which fair value is not subject to discounts, it is typically a pro rata value of 100%. Broadly, 10% of a company worth $100 would be $10 under those fair value statutes.
7.3 Formula Pricing.
This method does not equal fair market value but is, rather, a means to estimate that value. Formulas appeal to many parties to Buy-Sell Agreements because they are objective and inexpensive to determine. They may, however, miss subjective factors that influence fair market value. Clients using a formula price should revisit it periodically to make sure it is still representative of their intentions.
7.4 Book Value.
Value is sometimes defined as net book value as recorded in the entity’s records, tax returns or as determined under generally accepted accounting principles (GAAP). This value may be based on a company’s financial statement, audit or tax return. Net book value is not typically indicative of fair market value.
7.5 Value Based on Insurance Proceeds.
In a Buy-Sell Agreement, it is not uncommon for the purchase price of an interest in a closely held company to be the amount of an owner’s life or disability insurance policy proceeds. While this is a simple method, it may or may not approximate fair market value. This variance may cause problems for the redeemed owner.
7.6 Periodic Review and Consensus.
A company with several owners may periodically hold meetings to review and update an agreed upon value.
8. WARNING: DO NOT GIVE OWNERS AN INCENTIVE TO SELL.
Without a good understanding of the difference between the value specified in a Buy-Sell Agreement and true economic value, parties to a Buy-Sell Agreement may unwittingly provide owners a financial incentive to cause a triggering event and get bought out.
In the case of ABC Corp., all owners, including the newest owner “A,” were party to a Buy-Sell Agreement. Owner “A” had purchased his interest directly from the company based on a negotiated price tied to ABC Corp.’s GAAP book value. The negotiated price took into consideration a combined discount for lack of control and lack of marketability. However, terms of the Buy-Sell Agreements included a buyout provision under certain triggering events using the term fair value. Several months later, in the midst of a disagreement with his co-owners, “A” realized the Buy-Sell Agreement’s language would let him obtain more for his shares than he had paid for them. “A” caused a triggering event to occur and for his shares subsequently received “fair value,” which was finally determined to be a pro rata value of 100% of ABC Corp. “A” had effectively received a premium price over his negotiated buy-in price of only a few months prior.
9. LIFE INSURANCE FUNDING.
A crucial issue for a closely held business that wishes to buy out one of its principal owners is whether it will have the funds to do so. Because so few businesses have sufficient cash or other resources to fund a buyout, the seller usually must accept an installment payout and continue to share the risks of the future profitability of the business unless the business has provided for a fund to buy out a major owner. There are essentially three methods for funding a Buy-Sell Agreement:
• Setting up a sinking fund or reserve; or
• Acquiring insurance.
9.1 Cost of Insurance Versus Other Funding.
If a business has the borrowing capacity or available cash to fund a Buy-Sell Agreement, the cost of life insurance should be compared with the cost of borrowing money or using the company’s own funds. Today’s interest-crediting insurance contracts are extremely competitive and cost-effective. Consequently, the cost of insurance could be the least expensive option. However, there are many factors to consider in making this comparison, including the ages and health of the insureds, which could push premium rates to the point that the other options must be seriously considered, and the fact that the insurance may never be collected if it is purchased by the entity (e.g., if retirement occurs before death).
Often, total insurance costs may be controlled by using limited payment contracts that credit excess insurance company earnings or interest to the policy’s cash values. This approach may result in as few as 10-15 premium payments to pay for a contract in full. If this option is selected, care should be taken to test the contract performance under various interest rate assumptions.
A comparison of the cost of insurance against the cost of borrowing funds or using the available cash of the business can never be completely reliable. Assumptions must be made about future interest rates, fluctuations in the value of the business, future business needs for working capital, and dates of death of the insureds. The comparison should be based on an analysis that assumes that the policy will be maintained for a substantial time, usually until the anticipated retirement of the insured owner or partner. Policies are often kept longer, however, to provide the company with cost recovery, or they may be placed on a paid-up status and simply kept as an asset of the business.
Life insurance can assure the continuity of the business by providing a means of funding the orderly transfer of power, free of the potential threat of outside interests. For that reason, it may be helpful in obtaining financing (e.g., bank loans to continue or expand the business) and in giving a greater sense of security to key employees. Buying out a deceased owner with life insurance proceeds may also enable the business to take in a key employee as an equity owner.
9.3 Preserving Business Capital.
A standard reason for using life insurance to fund a buyout is that a business, although profitable, may have its assets committed to the business, making them unavailable to purchase its shares on short notice. Even when cash is available, the owners may prefer not to deplete capital for the buyout.
Although a business may not have accumulated cash, it may have the capacity to borrow money to purchase a deceased owner’s interest. However, the business may suffer if it must use its borrowing capacity to fund a buyout when the credit is needed to sustain or expand its operation. In addition, gross sales of the business may have to increase in order to maintain the ongoing after-tax cash flow necessary to make the payments on the loan or buyout.
9.4 Key Executive Insurance.
Life insurance may be used to compensate the business for the loss of the decedent’s services. Key executive insurance does not specifically fund a Buy-Sell Agreement, but it should be considered as part of the planning package when the agreement is being drafted. In a closely held business, the profits usually result from the services of the owners.
The Buy-Sell Agreement solves the problem of purchasing the decedent’s interest, but other problems may arise when an owner/employee leaves. For example, the business may have to pay substantial fees to an executive search firm to find a satisfactory replacement. Operating losses or reduced profits may occur during the transitional period until a replacement can be found and trained, and until business goodwill that had been developed by the decedent can be reestablished. The cost may be greater than the salary previously paid to the decedent if more than one replacement is needed. Key executive insurance can help with cash flow problems until the owner is replaced as an employee.
9.5 Owners’ and Survivors’ Needs.
A primary objective of life insurance funding is to ensure that the decedent’s estate will receive cash instead of a nonliquid investment in a closely held business. Not only will the estate and the beneficiaries be provided with cash by the insurance, they will also be relieved of the burden and responsibility of participating in and incurring risks from managing a closely held business. Moreover, the availability of cash will allow the remaining owners to avoid demands of the decedent’s estate or heirs to increase dividends or decrease salaries or other management powers, such as the ability to incur additional debt.
If life insurance will be used to fund the buyout, the owners must consider the amount and type of insurance that will be needed over the entire life of the agreement. During that time, some of the parties to the agreement may become uninsurable, or some future circumstance, such as an increase in the value of the business, may require that additional insurance be obtained if the agreement is to continue to meet the needs of the parties and the business. For example, if the available cash is limited, low-cost term insurance might be purchased with a view to converting the policy into permanent insurance or to buying additional insurance at specified ages. Flexibility may be added if permanent, rather than term, life insurance funding is elected by taking advantage of a “Substitute Life Rider,” offered by some companies at no additional cost. Care should be taken to avoid a transfer-for-value if this rider is used. Also available are other riders such as “Accounting Value” riders that are designed to reduce the impact of an insurance policy acquisition cost on the business financial statement.
9.6 Uninsurability Problem.
The uninsurability of one or more of the owners of the business can be an impediment to funding a Buy-Sell Agreement with life insurance. Insurance companies have been more willing in recent years to underwrite life insurance for individuals with severe medical problems, sometimes without additional premiums, but usually by charging higher premiums, depending on the degree of risk. The additional cost may rule out life insurance funding. This is why it is important to purchase insurance when the owners are young.
If a party is truly uninsurable, or if the cost of conventional individual life insurance is prohibitively high, other possibilities should be considered. “Second To Die” life insurance, which is more liberally underwritten, might also be considered if an owner is uninsurable. Structuring the Buy-Sell Agreement with an interest-only note until redemption could allow for freezing the value of the purchase as of the date of death, allow the heirs to receive interest income until redemption, and provide for redemption of the note at the death of the second party.
9.7 Partnership Ownership of Policies.
One tax savings structure is to set up a partnership, and have the partnership own the life insurance policy, pay the premiums (through partner capital contributions) and collect the proceeds on the death of the first owner. When the proceeds are collected, they will not be subject to income tax. They would be specially allocated to the surviving partners for income tax purposes, thereby increasing his income tax basis in his partnership interest. Next, the partnership would buy the deceased owner’s interest. Then, since the basis of the interest will or should be equal to the surviving owner’s basis in his partnership interest, the interest can be distributed to the surviving partner with a tax basis equal to the life insurance proceeds. Use of a partnership facilitates ownership of policies without causing inclusion of the proceeds in the estate of the decedent partner for estate tax purposes.
9.8 Disability Insurance.
A Buy-Sell Agreement may include a provision requiring the buying of disability insurance to provide funds to buy-out an owner on his disability. This may be an essential option for businesses that heavily rely on the services of its owners.
10. TAX PITFALLS.
Improperly structured Buy-Sell Agreement can produce unintended results. Sometimes inexperienced practitioners will recommend drafting a Buy-Sell Agreement in a way that subjects either the buying or the selling party to unnecessary taxes.
10.1 IRC §302.
One of the biggest pitfall involves violations of IRC §302, which applies to entities taxed as corporations. Redemption agreements, for example, can call for a sale of less than 100% of a shareholder’s interest in a company (as when an active shareholder wants to retire but maintain a reduced interest). However, the IRC §302(b)(2) substantially disproportionate requirement will not be met if, immediately after the redemption, the selling shareholder retains a 50%-or-greater interest in the combined voting power of all classes of stock entitled to vote.
In addition the IRC §302(b)(2) requirements will not be met if the shareholder retains an interest in the voting stock equal to, or in excess of, 80% of the voting stock he or she held before the redemption (in measuring these interests, IRC §318 constructive ownership rules apply). The 80% rule also applies to the corporation’s common stock (voting and nonvoting). On failing the IRC §302(b)(2) requirements, the redeeming shareholder’s limited interest redemption distribution will be taxed as dividend income, assuming one of the other redemption provisions is not met.
IRC §302(b) problems can be avoided when a shareholder’s death triggers the Buy-Sell Agreement if the redemption proceeds are limited to the amount of the shareholder’s estate tax and deductible funeral and administration expenses. In such a case, IRC §302 treats the transaction as a sale or exchange, regardless of the ownership percentage retained by heirs or other related parties. Other requirements also must be met.
10.2 Constructive Dividends.
If a cross-purchase agreement provides that continuing shareholders have a primary and unconditional obligation to buy shares on a triggering event, but the corporation instead purchases the stock under a secondary requirement in the Buy-Sell Agreement, the purchase is treated as a constructive dividend to the continuing shareholders. In a properly structured redemption agreement, the continuing shareholders are not directly affected by the acquisition (except for an increase in their ownership percentages).
To avoid this problem, the Buy-Sell Agreement should provide that shareholders have an option to purchase the stock rather than an unconditional obligation to do so.
10.3 Estate and Gift Tax.
If the buyout price is based on a formula price rather than the standard of fair market value, the value may not be acceptable for estate or gift tax purposes. A Buy-Sell Agreement may not impose a binding value for federal estate tax purposes. If an agreement fixes the value of a decedent’s interest and the estate is redeemed for that price, the IRS can challenge the amount and assess estate tax on fair market value, which may be higher than the contractual buyout amount.
To avoid this problem, a Buy-Sell Agreement should include a provision that requires the purchase price on the death of an owner to be no less than the value of the shares “as finally determined for federal estate tax purposes.”
11. BUILD A GOOD TEAM.
Buy-Sell Agreements, which formalize the wishes of two or more owners on an important issue, often are complex. Each party to the agreement has rights, obligations, tax considerations and financial consequences. Depending on the entity, preparing the contracts may involve a combination of consultants (to advise clients on succession issues), business valuators (to determine the entity’s value), tax professionals (to cite the relevant tax considerations and maximize value) and auditors (to deal with the contingent liabilities created by these off-balance-sheet agreements). Often a team of professionals from several disciplines develops the plans, which then are documented in the agreement.
Usually each party to a Buy-Sell Agreement is represented by an attorney, who ensures an agreement protects an owner’s interest, correctly represents his or her wishes and bestows rights and obligations that are appropriate and enforceable under local law. If the attorney drafting the document also is a tax professional, he will take steps to prepare a document designed to protect owners from adverse tax consequences.
Buy-Sell Agreements create substantial financial benefits and obligations that affect both buyer and seller. CPAs understand the impact of those, both from the business and the individual perspective, and many are uniquely qualified to address important income tax considerations for the buyer and the seller, estate planning for individuals and the effect of the purchase obligation on the business.
11.3 Insurance Agent.
Because life and disability insurance are common methods of funding based on death or disability triggers, a competent insurance agent can address this consideration and be a key member of the team developing the funding of a Buy-Sell Agreement.
There are a number of different methods for determining price in Buy-Sell Agreement, and a business valuation professional with the training, experience and credentials such as the AICPA’s ABV can provide useful input into how the parties to the agreement can benefit from the plan.
12. PRACTICAL TIPS TO REMEMBER.
• To help facilitate discussion to clarify owners’ choices, gather all parties to the agreement and their advisers at a neutral, comfortable site;
• Make sure the agreement anticipates the funding requirement of a buyout and includes a procedure to determine the purchase price;
• Resolve whether and when the Buy-Sell Agreement should be updated, how changes to it will be documented and what the consequences may be if the agreement is not updated;
• Include a provision in the Buy-Sell Agreement that requires the purchase price on the death of an owner to be no less than the value of the shares “as finally determined for federal estate tax purposes;”
• Make sure the valuation provisions do not provide an incentive for new owners to cause a triggering event and be bought out;
• To dissuade owner employees from leaving the company, some Buy-Sell Agreements give individuals who leave voluntarily or for misconduct as defined by the agreement less than they would otherwise receive. If an owner’s employment is terminated for cause, a “penalty price” such as net book value, some percentage of fair market value or a defined value may be applied; and
• Include language in the agreement to require purchase of a spouse’s ownership interest should he/she end up with an interest in the business in a divorce settlement. In any event, it is common to require the business owner’s spouse to become a party to the agreement. Spouses should have independent legal counsel.
13. S CORPORATION.
If a corporation has been structured as an S corporation, it requires special provisions in the Buy-Sell Agreement to protect its S corporation status.
Buy-Sell Agreements can be a valuable tool for closely held businesses and owners who want to protect their ownership interests. But if drafted improperly, these contracts can cause problems for both buying and selling parties.