In part 1 of this post, we talked about the importance of business succession planning. Specifically, part of establishing your business should include serious consideration of a plan for how to handle owner divorce, exit or death. What would be the ideal outcome for the transfer of that partner or shareholder’s ownership interest? What outcomes are desired or problems are important to prevent?
We described in part 1 the kinds of issues that can arise if you do not carefully set up a structure for such transitions. You can establish this plan through a buy-sell agreement.
Buy-sell agreements plan for future ownership transitions
Business owners can avoid these kinds of unwanted outcomes if the business executes a buy-sell agreement from the inception that predetermines what the transition will look like when an owner leaves for a variety of reasons – called triggering events. Exit planning is another term for securing binding plans for these situations. While slightly different, but with similar concerns, owner divorce may also be a triggering event.
For example, say the owners only want to keep the business going if they can remain the sole owners – they do not want to involve a new owner or business partner. A buy-sell agreement could provide that the death of an owner will be a triggering event that activates certain steps provided for in the contract. Many buy-sell plans provide that the deceased owner’s shares will be bought by the remaining owners or by the business itself, or that the owners or the business would get the right of first refusal (the option to buy the interest before it is offered to anyone else).
Life insurance
Sometimes owners use life insurance to fund this buy-back. Each owner would have a policy on each of the other owners’ lives providing money to purchase back the shares upon one of their deaths.
Other owner exit events
A Forbes article describes several potential scenarios where a buy-sell agreement could be helpful such as how to structure the transfer of ownership should a partner leave voluntarily or to retire. How would that partner be bought out if the other owners do not want an outsider to purchase the share? Would the business set aside money periodically from profits to plan for this eventuality, would they consider a loan or would they choose to issue new shares?
Valuation
Another key provision of most buy-sell agreements is how to value the shares or ownership interest at a time of transition. They might agree on a formula, tie it to fair market value, allow a professional to determine the value or another method.
This introduces an agreement that business partners can use creatively depending on the unique needs of a business and its owners. There are other, more complicated issues that we will discuss in future posts such as related tax considerations and approaches to take should ownership interests not be equal.
