Maximizing the Buy/Sell Agreement Potential
Agreements that work for both death and lifetime transfers
Buy/sell agreements are absolutely critical to succession planning, but are too often neglected. Even when they are set up, they are generally structured to be funded by life insurance proceeds, in the event of death, rather than company cash flow. John H. Brown explains why this can be a big mistake and how certified valuation analysts (CVAs) are in a unique position to help business owners successfully avoid common pitfalls by planning for all possible scenarios.
During my 30-year legal career, Iâ€™ve reviewed more than my share of business continuity agreements, and Iâ€™m continually amazed at how a document that has the potential to do so much is often designed to do so little.Â When creating these agreements, most owners (and their advisors) diminish the possibility of lifetime transfers and wrongly assume that ownership is most likely to transfer because of death, and thus proceeds from a life insurance policy, rather than company cash flow, will fund the purchase of the deceased ownerâ€™s interest. Second, those who did consider cash flow as a funding mechanism rarely anticipated that it would be as dear as it is today or that the value of their companies might decline in turbulent economic times.
These oversights present two opportunities to the Certified Valuation Analyst (CVA). Â The first, and best opportunity, is to alert and explain to owners (and often to their other legal and financial advisors) when they are either creating or revising a buy/sell, that a contemplated or existing Â valuation formula or methodology used for a death transfer will likely cause problems in the event of a lifetime transfer (divorce, owner dispute, bankruptcy, or retirement of a shareholder).Â The CVA can help owners to understand why they should go beyond a simple right of first refusal should one owner wish to transfer ownership to anyone by sharing an all-too-common story.Â
Here is the story that will illustrate the above points. H&T Custom Tack almost didnâ€™t get out of the corral. Harry and Tom had talked about pooling their resources (Harryâ€™s thriving tack business and Tomâ€™s reputation as one of the best custom saddle makers in Texas) for years when Tomâ€™s twin brother had a heart attack at age 55. Tom realized that life was too short to keep talking about creating a partnership and the two decided to merge their talents at last.
Along with all of the other documents that Tom and Harryâ€™s attorney insisted on was a buy/sell agreement that established the price and the terms of the sale or purchase. Embedded in its creation was the assumption that one of them (probably Tom since he was eight years older than Harry) would die and Harry would purchase Tomâ€™s ownership using life insurance proceeds.Â
The good news was that Tom answered the wake-up call to improve his lifestyle. He not only created a successful company, he replaced his daily drive across town to grab a chicken-fried steak or cheeseburger with brisk walks to the new vegetarian salad joint. He joined his wife for long bike rides on weekends and boasted that heâ€™d never felt better.
The â€śbadâ€ť news was that before either of them rode off to join the Big Rodeo in the Sky, Harry began to think about retiring and selling out. A quick look at the buy/sell agreement told him that he had to sell his stock to Tom based upon the price they had established when they assumed that there would be more than adequate funding because of the existence of a life insurance policy.Â
Harry and Tomâ€™s problems were just beginning. Because the price established in their buy/sell agreement had nothing to do with the fair market value of the company when one of them wanted to sell out, the price the buyer would pay was likely to be substantially higher or lower than the companyâ€™s current value. This means that one or the other partner would suffer.
As you know, some owners resolve this problem by agreeing to ignore their buy/sell agreement and to hire a Certified Valuation Analyst to establish a fair market value for the company. A CVA called upon in this situation has an additional opportunity to help owners: (1) resolve a problem they didnâ€™t foresee, (2) create a way to cash out a shareholder without siphoning off the companyâ€™s cash flow, and (3) establish a current â€śfair market valueâ€ť for the company.
In the story, Harry suggested this route, but Tom insisted that they abide by their original agreement. First, Tom did not want to put a damper on the future growth of the company by siphoning off its cash flow toward Harryâ€™s buyout. Second, the predetermined value in the buy/sell agreement was significantly lower than the companyâ€™s current value.
Harry felt he had proposed a fair alternative, resented Tomâ€™s intransigence, and didnâ€™t want to sell his ownership interest for what he believed was an artificially low price. As you can imagine, the two partners stopped speaking.
Harryâ€™s issue with the price was just the first hurdle. Because Harry and Tom had presumed that only death would separate them, they had done no planning to minimize the tax consequences of a lifetime sale. Further, since they assumed the survivor would use life insurance proceeds (rather than company cash flow) to fund the buyout of the deceased shareholderâ€™s interest, they had established a very shortâ€”only four-yearâ€”timeframe to pay for the purchase. Finally, their buy/sell included no â€śforced buyout provisionâ€ť to resolve irreconcilable differences between the owners.
In short, the only way for Harry to leave the company with the amount of cash he felt he was owed was to die. Until he could do that, he was left owning a company whose performance he had little reason to improve.
Armed with CVA training and expertise, the CVA can play a huge role in helping owners to prevent this impasseâ€”if they know about it. Â If you are a CVA and havenâ€™t reviewed your clientsâ€™ buy/sell agreement, call them today. Ask them if you can quickly check their agreements to ensure that they deal with lifetime transfer events as if such events might actually happen! Had Harry or Tom received your call, their business venture might have avoided disaster.
In addition, talk to other referral sources about the dangers lurking in many, perhaps most, buy/sell agreements and how a review of these agreements can prevent much anguish among owners and advisors alike. Grab this wonderful opportunity to help owners, strengthen referral relationships, expand your network to include insurance professionals, and gain new clients.
[author] [author_image timthumb=’on’]https://www.exitplanningforadvisors.com/images/john-brown-2.jpg[/author_image] [author_info]John H. Brown, Esq., Â is president of the Business Enterprise Institute. John can be reached atÂ firstname.lastname@example.org[/author_info] [/author]