The Importance of Handling Buy-Sell Agreements with Care
From Carr, Riggs & Ingram
A buy-sell agreement is a valuable document to have on hand if you own any type of interest in a closely-held or family-owned business. These types of agreements will identify whether, and under what circumstances, the owners’ interests transfer. To ensure that the agreement doesn’t trigger any unwanted tax consequences, create a conflict with other existing owners or family members, and meets expectations that you set, it’s important to precisely plan and draft the document.
Benefits to Consider
Any well-executed buy-sell agreement will provide involved parties a number of benefits that include:
- Ownership will be able to stay within the family or another group selected by the selling-party—for example, someone who has been actively involved in the enterprise.
- In the event of a divorce, this agreement would avert a former spouse of the owner from obtaining a business interest.
- Should there be an instance of death or disability, it would provide the owners and heirs liquidity to pay estate taxes and any other potential expense.
- If specific requirements are met, it will establish a value of the business for gift and estate tax.
- Ownership succession disputes would be minimized and possibly put to rest.
By allowing the company or remaining owners to purchase the interest of a previous owner who has passed away, become disabled, or has chosen to leave the business, the agreement to achieves the objectives above. It may also provide the remaining owners, or the company as a whole, a right of first refusal in the event that an owner has chosen to sell his or her interest in the business.
Choose a Fair Price
In order to avoid any unpleasant conflicts or potential surprises, it is critical to agree upon a valuation provision. In general, conducting periodic independent business valuation and establishing a price based on fair market value have proven to be the most reasonable and effective method to set purchase price.
It is also common for the agreement to set the purchase price based on a formula tied to earnings, cash flow, book value, or other objective measures. While it can be argued that formulas have the ability to offer more simplicity and lower cost options, they are unable to account for factors that drive a business’ value or any other characteristics that tend to be subjective. The results are disputes due to an underestimated, or overestimated, business value brought on by the invocation of the buy-sell agreement.
Knowing the Difference
While the terms “buy-sell agreement” and “shareholders’ agreement” are often used in place of one another, a shareholders’ agreement refers to a more broad category in which a buy-sell agreement is only a subset.
While a buy-sell agreement deals specifically with the share distribution of a shareholder who passes away, has chosen to sell his or her ownership, or has become disabled, a shareholders’ agreement is more likely to include a buy-sell provision. This type of agreement also includes nonsolicitation, noncompetition, confidentiality restrictions, voting procedures, dispute resolution mechanisms, and many other provisions that are related to shareholder relationships or corporate governance.
Consider All Scenarios
Before you sign a buy-sell agreement, it’s essential to do some type of testing that will show you how the agreement will perform in different scenarios. These tests will allow you to carefully choose the wording in your agreement that will meet and fulfill your objectives. If you are considering entering into a buy-sell agreement, consult your CRI tax advisor for answers to your questions!