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.