When is the last time you reviewed your company’s buy-sell agreement? If you’re like the owners of many private companies, that document is sitting in a file collecting dust. The stagnant legal document is often viewed as something that you create and then put away, only looking at if a business partner dies, retires, gets sick or decides to leave.

But that is a big mistake, says Mario O. Vicari, director at Kreischer Miller in Horsham, Pa.

“The buy-sell agreement is a critical roadmap that outlines the economic terms and conditions of transactions between a company and its shareholders in case of a triggering event in a private company’s stock,” says Vicari. ”It essentially determines the market for the company’s stock among shareholders.”

The buy-sell agreement is a highly customized document that a company’s shareholders should intimately understand and should play an active role in crafting so that it reflects their collective intent.

Smart Business spoke with Vicari about how to execute an effective buy-sell agreement.

What is the purpose of a buy-sell agreement?

First, when structured properly, a buy-sell agreement reflects the intent and the bargain of shareholders relative to transactions in a private company’s stock.  For this to occur, shareholders should participate in the crafting of the document and its provisions, and review it at least annually.

Second, the agreement protects the company by ensuring that its provisions do not present a set of economic circumstances that could jeopardize the company’s liquidity by requiring it to fund a transaction that was not planned for or properly structured.  Important elements to consider are reasonable valuation and payment provisions.

Third, it protects the shareholders and their families by providing funding mechanisms through proper insurance coverage in the event of an untimely death of a shareholder. Finally, a properly structured and monitored agreement helps avoid shareholder disputes and litigation because the economic provisions are well understood and agreed to by all parties in advance of any triggering events, and the valuation is monitored annually.

What are the important triggering events that should be addressed in a buy-sell agreement?

There are five major triggering events that are normally addressed in a buy-sell agreement: death, disability, separation from employment, retirement and sale. It is important to note that each trigger could cause different terms and conditions in the agreement, such as length of payout or discount on valuation.  For instance, a company can protect itself from an unanticipated liquidity event caused by an unplanned separation from the company by placing a discount on the valuation and/or longer payment terms on that transaction trigger.

There are two other common triggers — divorce and bankruptcy of a shareholder.  In each of these cases, company stock could become part of a divorce or credit estate and the holder of those shares would have the same rights as the other shareholders.  In order to avoid this type of situation, a well-designed agreement can prevent a shareholder from allowing shares to fall into someone else’s hands by requiring the shareholder to ‘put,’ or sell their shares back to the company in exchange for a note before the divorce or credit action is settled.

What are common mistakes that business owners make in these agreements?

The most common mistake is having a provision that the company’s value is to be determined by an outside appraiser in case of a triggering event. This causes problems on several fronts. First, when shareholders don’t understand the value of their shares within the agreement, they are often surprised when a trigger occurs. This sometimes leads to bad feelings, disputes or litigation. It also does not allow shareholders to properly plan their personal affairs.

Second, when an important variable in the agreement such as the value of the shares is not known, it is impossible to know whether other elements of the agreement are properly structured, such as the amount of life insurance to carry or whether the company can afford the payout provisions. A better strategy is for the shareholders, with the help of a valuation adviser, to develop a formula that is contained in the agreement that can be measured and quantified each year after the company’s financial statements are complete.

This allows shareholders to monitor the value for their sake, as well as the company’s, and to make sure that the valuation and payment provisions are reasonable in light of the company’s current financial position and cash flows.

Who should be involved in drafting a buy-sell agreement?

We think that balanced advice is very important. Certainly, all the shareholders should be active participants, as it is their company and their stock. We also think it is a good idea to include the company’s financial officer.

Outside advisers should include the company’s CPA, attorney and insurance counsel. If the company’s CPA does not have valuation expertise or credentials such as a CVA, then a valuation adviser may also be needed.

Mario O. Vicari is a director at Kreischer Miller, Horsham, Pa. Reach him at mvicari@kmco.com or (215) 441-4600. Follow him on Twitter @mariovicari.

Insights Accounting & Consulting is brought to you by Kreischer Miller

Published in Philadelphia