In my March post about estate planning for small business owners, I mentioned that one way owners can plan for their business after death is by selling it to an existing business partner. Often, such sales are completed by using a buy-sell agreement. To delve a little bit deeper into that topic, this post considers three key elements that every buy-sell agreement should include.
1. Specify What Triggers the Buyout Obligation
The buy-sell agreement should define what events will trigger the buyout obligation. Obviously, for estate planning, one of those triggers should be the death of a partner.
But it can also be triggered by more than just that. For example, some buy-sell agreements treat a partner’s divorce as a trigger for the buyout obligation. Others treat bankruptcy the same way. The thinking is that the other business partners shouldn’t be forced to allow an unknown and potentially unwanted partner to join the company.
Another possible trigger is the departure of one of the partners from the company, either willingly or unwillingly. In many cases, it will make sense to treat a willing departure differently from an unwilling departure.
Whatever buyout triggers the partners agree to include, the bottom line is that they should think carefully about potential triggering events when making the agreement.
2. Detail the Buyout Procedure
The buyout procedure is the heart of the buy-sell agreement, so the partners should take their time considering how they want buyouts to work. How soon after a triggering event will the other partners have to pay the deceased/divorced/bankrupt/departed partner? What remedies will be available to force a recalcitrant partner to buy or sell when the agreement requires it?
Another important consideration: What will be the buyout price? There are a few different ways to define this:
- Fixed amount: A fixed amount has the advantage of being simple, but the disadvantage of potentially being unrealistic. The actual value of the company may differ substantially when the triggering event occurs from what it was when the agreement was made.
- Formula: A formula for calculating the buyout price can be more realistic than a fixed amount, but it, too, may be inadequate to capture the company’s true value.
- Appraisal: Hiring an appraiser to determine the value of the company and of the interest being bought out is the most accurate approach to setting that value. On the downside, it’s also the most expensive. If the partners choose to use an appraisal, they should agree ahead of time on an appraiser or on a method for choosing an appraiser.
- 3. Provide for Financing
As I’ve noted before, buy-sell agreements often contemplate funding via a life insurance policy. But life insurance policies won’t be of much use if the triggering event is something other than a partner’s death. Consequently, the agreement should explain how the payment is to be funded. This could be by a bank loan or simply by permitting the remaining partners to pay the buyout price over a set period.
Getting a buy-sell agreement right requires working with professionals—possibly more than one. A business lawyer may be best suited to draft the agreement, but at a minimum, the partners should consult an estate planning attorney to ensure that the agreement fits in with their overall estate plans. In addition, the advice of a CPA regarding the tax consequences of a buy-sell agreement can protect the partners against unanticipated liabilities from a buyout.
If you are a small business owner and are considering making a buy-sell agreement with your business partners, please contact me so I can help you understand how your agreement will affect your estate plan.