Prepare for the Unexpected – Reviewing Your Buy/Sell Agreement

Will Hendricks and Jay Halverson, Estate & Business Planning Specialists, First Republic Private Wealth Management
June 3, 2020

Hundreds of new businesses are formed each day in the United States. Founding partners come together with an idea, map out a plan, take all the right steps to set up the corporate structure, create formation documents and get their business off the ground. They put their heads down working in their business, and the years fly by. The company grows, and life – both personal and professional – becomes more complicated.

Suddenly, an unexpected trigger event requires that a founding partner’s controlling interest in the company be transferred. The need may be the result of premature death, career-ending illness, a complicated divorce or merely a decision to retire early. Whatever the cause, we find most often that when this happens, those long-forgotten formation documents are pulled out of a filing cabinet, dusted off and, read-only to discover that the terms are going to cause more harm than good. What now?

Not having a clear, written plan can put an entire business at risk. Departing partners and surviving family members could potentially be forced to walk away with far less than what they should have received. Conversely, a poorly written or non-existent buy/sell agreement could leave the remaining partners with a potentially crippling buyout liability and put the business at risk.

Having buy/sell provisions in place from the beginning, and regularly updating them is a crucial step that entrepreneurs often overlook when they start. Investing time early on to have these sometimes difficult conversations ensures that all stakeholders are on the same page, and can help mitigate the emotional and financial burden of an unforeseen or contentious transition in the future. Not only will business owners build a stronger foundation for their company, but addressing these loose ends can increase the value of the company over the long run.

Every business needs a contingency plan – in writing

A client once confessed to us that they give better advice to their in-laws about what to do with their kids over a long weekend than what to do with their company if they didn’t make it through the door the next day. From a business continuity standpoint, the riskiest plan is the one that exists in an owner’s head and not on paper. Now more than ever, updating or creating a written contingency plan and letting family members, employees, clients and lenders know that it exists can be the difference between weathering the storm and being forced to shut down.

Business valuation – make sure it works for everyone

One of the biggest sticking points of any agreement is determining how the business will be valued when a transfer of ownership needs to occur. Many business owners, and the advisors who draft these agreements, believe the best way to establish a value is by appraisal. Not only can an appraisal be time-consuming, but it can also create unnecessary expenses when cash flow might be an issue.

We often see up to three appraisals required if there is any disagreement between the parties. While formal business valuations are often necessary when selling to an outside buyer, there can be a simpler way to value the business. Many business owners use the “Agreed Value” method as an alternative approach. Simply put, Agreed Value means that the owners meet at least annually and decide, among themselves, the value of their business.

Owners should also have a backup methodology for valuation in the event they skip the annual meeting. The most common method is formula-based, a multiple of revenues, earnings or whatever makes sense for the business – as long as the formula is accepted and agreed upon by all.

Think through payment terms

In our work with clients, we focus on playing out the real-life consequences of a particular event occurring, modeling the terms as they exist in their existing agreement, and asking: would you or your family be happy with the outcome? Often the answer is “no.”

Buyout payment terms should be structured in a way that provides the business with flexibility and time. We often see the initial down payment percentage being unrealistically high, or the duration of the note payment being too short. We often hear the question – “Where am I going to get the cash for a 40% down payment within 30 days?”

In most situations, insurance is an inexpensive tool that can be used to provide tax-free liquidity in the event of a death or career-ending illness. Still, other triggers such as bankruptcy or divorce cannot be insured. Most owners are also surprised to learn that note payments are non-deductible. By establishing clear, realistic buyout terms from the outset, and leaving room to make adjustments over time, business owners can lay the foundation for a successful transition.

Other considerations

There are several other components of the agreement that should be considered depending on the industry. Are the partners involved in real estate development on the hook for construction guarantees of a particular project, or would they be in technical default of a loan if a partner passes away? Does a potential buyer of a dentist practice need to satisfy certain medical requirements to be a permitted purchaser? Is your long-time partner comfortable being in business with your spouse or adult children when you are no longer around?

Call to action

Don’t let an out of date agreement define your legacy. Now more than ever, we urge our clients and fellow business owners to come up for air and invest well-spent time working on their business. Dust off your agreement you probably haven’t looked at in years, review the provisions and make sure you and your partners can live with the terms. Task your advisors to take the project off your punch list and complete the necessary changes - it doesn’t always need to be an expensive or time-consuming effort. Unfortunately, many of the stories we hear about non-existent agreements or out of date terms – and the ensuing drama – could have been avoided with a little emphasis on staying current. We take pride that our business clients sleep a bit better at night, knowing that their planning loose ends have been addressed.