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What Does the Future Hold for Your Business? Funding the Buyout Under the Buy-Sell Agreement

2/25/2013

 
by Kim Coogan
Part 4 of a 5 Part Series

You know you need to establish a succession plan for your business; you've identified and continue to develop individuals to whom the management, executive decision-making, and ownership of your business will pass. You recognize the importance of documenting your intentions for the future ownership of your business using a "buy-sell agreement."

Now you have to ask yourself the not-so-simple question, "If I pass away or retire and my interest is sold, how will I, or my family, be paid?" Or, "If my partner dies or wants out, how will I pay him or her, or his or her family, if I have to buy out his or her interest?" The answers to these questions will be different if the buyout occurs during lifetime as opposed to upon the death of an owner.

The buy-sell agreement should set forth the terms of payment of the purchase price, which will be determined in accordance with the valuation provisions of the agreement. In the event of the departure, retirement, disability or other lifetime buyout event of an owner, typically the agreement will allow for a promissory note evidencing the obligation to pay the purchase price over time. The term of the note may be principal and interest payments over 5, 10, or more years. The interest rate will be set at the time of the buyout, based on an index, e.g. prime rate, or the applicable federal rate, as published by a specific source. The note will most likely be secured by the pledge of the business interests being purchased.

Upon the death of an owner, the buyout may be funded either in the same manner as a lifetime buyout, or more commonly, with the proceeds from a life insurance policy on the life of the deceased owner. If the buy-sell agreement is a redemption agreement, whereby the business entity buys out the interest of the deceased owner, then the business entity will own the life insurance policies on the lives of the business owners. Upon the death of an owner, the business entity will pay out the agreed purchase price to the business owner's estate, or trust, depending on how the business interests were owned. The business interests will be transferred by the deceased owner's successor in interest to the business entity.

If the buyout is a cross purchase, then the surviving business owners will pay the agreed purchase price to the deceased owner's successor in interest. If there are two owners, then each would own a life insurance policy on the life of the other. In the case of a business with multiple owners, insurance can become more complicated. For example, with three owners, each would have to buy life insurance on two other owners. In total, there would be six life insurance policies. This can become somewhat cumbersome. An alternative might be a trusteed buy-sell agreement, whereby one life insurance policy on each of the owners is owned by an escrow agent (or "trustee"). Upon the death of an owner, the trustee collects and pays out the insurance proceeds to the deceased owner's successor in interest in exchange for the shares in the business. The escrow agent then allocates the shares among the surviving owners.

Congratulations! You've consulted with your professional advisors; you've done the hard work of considering who will carry on your vision for your business after you step away from it; you've laid the groundwork for management, leadership and ownership succession; and you've documented all of this in a well-written buy-sell agreement. You've obtained the proper life insurance or other mechanism to fund a potential buyout. You are doing great! But your work isn't done. It's a work in progress. You should revisit your business succession plan annually, and re-evaluate your management and leadership to ensure your plan is on track, and make any necessary adjustments. Your attorney, accountant, and insurance professional should work together with you to make sure your plan is the best it can be for you and your business.

What Does the Future Hold for Your Business? Every Business Owner Should Have a Buy-Sell Agreement

2/12/2013

 
by Kim Coogan
Part 3 of a 5 Part Series

In Part 1, we recognized the need to establish a succession plan for your business; and we discussed the importance of identifying and developing individuals to whom the management, executive decision-making, and ownership of your business will pass. Whether you determine that the business should pass to family members, key employees, or will be sold to a third party, it is critical that you document your intentions in a document often referred to as a "buy-sell agreement."

A buy-sell agreement is an agreement among the owners of a business, or between the sole owner and certain key employees, which sets forth the conditions under which ownership interests in the business may be transferred. One of the goals of such an agreement is to prevent the entity ownership from landing in the hands of the spouse of a deceased owner, the ex-spouse of an owner, or children who are not involved in the business. The agreement lists certain events, e.g. death, disability, departure or retirement of a business owner, the desire to sell to a third party, or the entry of a divorce or bankruptcy court order, which would trigger a buyout by the remaining owner(s) or key employee(s).


The agreement may be in the form of a redemption agreement, under which the business entity itself buys the business interest from the transferring owner. Alternatively, it may be a cross-purchase agreement, under which the remaining owner(s) buy the interests of the transferring owner; or it may be a hybrid agreement, which allows either the entity or individual owners to buy the interest. The agreement may provide for rights of first refusal, or a mandatory buyout by one party of the other party's interests in the business. There may be put and call options, giving an owner the right to require the other owner(s) to buy his or her interest, or sell their interests to the calling owner. The buy-sell agreement should also address the conditions under which an owner may transfer his or her interests by gift or sale to his or her descendants, or to a trust for their benefit, without triggering a buyout by the other party to the agreement.


A critical component of the buy-sell agreement is the valuation mechanism used to determine the purchase price for the business interest. There may be a specific formula included, or a provision that a valuation will be obtained from a professional valuation expert. Different methods of valuation may be applied, depending on the circumstances of the buyout. For example, book value might be used in a divorce or bankruptcy situation, and fair market value might be used for a death or disability situation. There might be a discount on the buyout price for a "put" and a premium on a "call." The parties should review the valuation provisions annually to ensure they remain appropriate, given changes in the industry, the market, and the business' financial condition.


Another critical question that must be considered is how the buyout will be funded. We will address funding in the next installment of this series on business succession planning. Note, however, that the method of funding and the design of the buy-sell agreement must be coordinated, so it is important to consider these issues concurrently.

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The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.
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915 Harger Road, Suite 240 
Oak Brook, Illinois 60523 




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