Business owners who have done their homework know the importance of buy-sell agreements.
When a buy-sell agreement is properly established, it protects the partners, owners and employees by ensuring the continuation of the business when one owner leaves or is unable to continue with the business. In short, buy-sell agreements detail how the departing owner’s shares will be bought out.
The problem with many buy-sell agreements, however, is that templates often are used to set up the paperwork, with little thought given to how the agreement can best serve that particular business. Here are some common mistakes to avoid in buy-sell agreements:
1. Failure to fund — In situations in which the business has two owners and each agrees to buy out the other’s part, problems occur when they don’t decide beforehand where the money will come from to purchase the other’s half. Few owners have the cash available to buy the other’s shares or interest, and banks may be reluctant to lend the remaining owner money at a time when the business is transitioning ownership.
One solution is to purchase a life insurance policy and/or disability buy-out policy on each partner or shareholder in the amount needed to buy out the other owner in the event of death or disability. But keep in mind that such policies create severe tax consequences if they’re not structured properly.
2. Deciding the purchase price — When a business is starting, this is an easy decision to make once the owners agree upon the value of the business. Problems arise, when a business is a few years old, in determining an acceptable valuation relative to both the Internal Revenue Service and the owner who is being bought out.
Serious disputes could arise if the business is not revalued annually. What if one owner leaves and takes customers with him? This could hurt the business, and perhaps the departing owner should receive a smaller price for his percentage of ownership.
One way to address the problem is to use a formula to value the business. However, the formula must be realistic, such as a multiple of one times the annual revenue or five times the average annual net profit of the last three years.
3. Owner equality — Sometimes a majority owner may not want owners with a smaller share buy him out. He may want a family member or key employee to have majority ownership. A standard buy-sell agreement can prevent this from happening. Also, two buy-sell agreements can be created to suit the needs of both the majority shareholder and owners with a smaller share.
4. Missing triggers — Almost all buy-sell agreements indicate that, in the event of the death or retirement of one owner, the buy-sell option is triggered. But what happens in the case of a disability, divorce or personal bankruptcy? In a divorce, the stock could be awarded to a spouse or, in the event of bankruptcy, to a creditor — which may not be desirable for the remaining owners. Another triggering event that should be considered is the firing of an owner with a smaller percentage ownership.
5. Refusing the right of first refusal — The right of first refusal states that the departing owner cannot sell his interest without first offering it to the remaining owners. This is a common provision, but if it’s not included in the agreement, the remaining owners may not have the opportunity to purchase the other’s share, and it may be sold to a new owner who may not have the same viewpoints as the remaining owners.
By tailoring an agreement to meet the particular needs of a business, these and other common buy-sell agreement problems can be anticipated and avoided.
Louis P. Stanasolovich, named one of the best financial advisers in America the last four years by Worth magazine, is founder and president of Legend Financial Advisors, Inc., a fee-only financial advisory firm in the North Hills of Pittsburgh. Reach him at (412) 635-9210. The firm’s Web site is www.legend-financial.com.
