In our last post on buy-sell agreements, we discussed how a well-crafted buy-sell agreement provides peace of mind to business owners and their key employees. Hopefully, we have convinced you that undertaking the task of developing an agreement or updating your existing one is well worth it. But, what exactly should be included in a buy-sell agreement? Based on our experiences with business owners, we think that the following four components are essential.
- Restrictions on Ownership Transfers. Your buy-sell agreement controls who can own stock, when stock can be transferred and how stock is transferred. It should include restrictions on a shareholder’s ability to transfer his or her shares. Other owners are often given the right of a first refusal to match the offer presented by a third party or an option to purchase the ownership interest being transferred.
- Events Triggering a Buyout. The specific conditions or events that will cause the buy-sell agreement to be “triggered” should be defined in your agreement. Events that should be considered include the following:
- Voluntary transfer by an owner;
- Involuntary transfer by an owner (caused by divorce, bankruptcy, or creditor action, etc.);
- Death of an owner;
- Disability of an owner;
- Termination of employment of an owner (voluntary and involuntary); and
- Irreconcilable deadlock among owners.
- Valuation of Shares. This is often the weakest link in buy-sell agreements. We recommend that buy-sell agreements establish exactly how the business will be valued upon a triggering event. Be wary of formulas or fixed-prices because these valuation methods often do not reflect fair market value. Ideally, the business’ value should be initially determined by a credentialed valuation expert and updated at predetermined intervals and/or upon a triggering event. This ensures that all parties understand the valuation approach and conclusion and helps to avoid surprises. The standard of value, level of value, “as of” date, qualifications of appraiser and appraisal standards should also be addressed.
- Funding the Buy-out. The agreement should establish the funding source(s) that will be available for the purchase of the shares in accordance with the conditions of the agreement. Life insurance, cash, promissory notes and external financing are common mechanisms to fund shareholder buy-outs. Understanding the advantages and disadvantages of each option is an important step in the process of creating an effective buy-sell agreement.
While the above elements are certainly not the only issues addressed in a buy-sell agreement, they are critical. Buy-sell agreements must be drafted in a manner that make them legally binding on the parties to the agreement. Business owners need to rely on their legal counsel regarding such matters.
Have questions about establishing or updating your buy-sell agreement. Contact Paula K. Barrett, CPA/ABV, CVA, partner and leader of RKL’s Business Consulting Services Group, at firstname.lastname@example.org or 610.376.1595.
Contributed by Paula K. Barrett, CPA/ABV, CVA, partner and leader of RKL’s Business Consulting Services Group. Paula specializes in business valuation and litigation support services, assisting clients in the acquisition or sale of closely-held businesses and general business planning services. She also has experience in tax-exempt bond financing services, including bond verifications and arbitrage rebate computations.