Buy-Sell Agreements

• Do you have children or family members willing to take over the business?
• Do any of your heirs have the experience necessary to run your business?
• Do your partner’s family members have the knowledge and commitment to join the business?
• Would you want your partners’ family as business partners?
• How would the company afford to survive if you or a key partner were disabled or died?
• Would your heirs or partners be forced to sell the business to pay your estate and taxes?
• Is your business and estate planning structured to reduce or eliminate various taxes?
• Will your heirs or those of your partners get a fair price when it comes time for a buy-out?

• Conflicts and possibly even litigation between the deceased owner’s heirs and the surviving owners
• Delays in the transition to successor ownership and in settling the deceased owner’s estate
• Potential loss of customers, key employees and creditor confidence that damage the business

Show Example

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Example Of A Cross-Purchase Buy-Sell Agreement At Work
Assume three partners own equal shares in a business
and each owner’s share is valued at $100,000

To protect the business from having outsiders (non-partners) such as partner family members or potential buyers of family-owned interest, the partners agree that only the original partners may buy the shares of any partner who dies. Since the death of a partner could be sudden and unexpected, requiring the company to find funds to immediately pay for the deceased partner’s share of the company. It is decided that insurance provides the best solution to funding the buyout.

In this example, each of the three owners purchases a life insurance policy in the amount of $50,000 on the life of their two partners, thus providing $100,000 to buy the share of the company owned by any partner to die. Thus, each partner is purchasing two $50,000 policies:



Each partner owns the policies that they buy covering the lives of the other owners and is the named beneficiary of those policies. If a partner dies, the surviving partners will each receive a $50,000 death benefit from the insurance policy they carried on the deceased partner and each use the funds to purchase the deceased partner’s share of the business which was valued at $100,000 as illustrated above.

All Things Being Equal
Cross-purchase agreements state that ownership percentage of each owner will remain the same before and after a cross-purchase event. For example, partner 1 owns 60% of the business, partner 2 owns 30% and partner 3 owns 10%. If partner 3 dies, partner 1 will still own twice that of partner 2:

Present Position		Position After Death of Partner 3
Partner1 owns 60%		Partner1 owns 66⅔%
Partner2 owns 30%		Partner2 owns 33⅓%
Partner3 owns 10%

Tax Advantage of Cross-Purchase Insurance
Premiums paid by each owner are not tax-deductible, however a business corporation that pays the premiums on behalf of shareholder-employees may be able to deduct the cost of the premiums as a business expense. The shareholder-employee amounts must be reported as income, compensation or dividends.

Policy proceeds are generally received without federal income tax subject to rules in reference to transfer of policies for a valuable consideration and surviving partners will receive a step-up in basis which is desirable because it reduces the amount of taxable capital gain upon a future sale of the business.

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• Death of Owner or Partner(s)
• Disability of Owner or Partner(s)
• Separation or Divorce of Owner or Partner(s)
• Retirement of Owner or Partner(s)

• Business Valuation
Valuing the business properly and fairly (fair market value) is a critical component of a Buy-Sell Agreement for the obvious reason that when a triggering event takes place, both buyer and seller want to be confident that they are getting a fair deal. Value should be declared for both the company and for each owner’s share. It is advisable to consult your tax advisor and a business valuation specialist. Your BCG business succession and continuation consultant can help you undertake the business valuation process.

Business Valuation Methods
The primary objective of the valuation process is to establish a close estimate of the business’s fair market value. Discounted valuation is applied where less than entire ownership interest is being acquired. Some of the more common business valuation methods are summarized below.

Book value
This valuation process, also known as the net asset value (NAV), calculates assets minus liabilities to establish the net worth of the business. This quick method of valuation is less accurate over time due to the fluctuating and often rapid value increases or decreases in intangible assets such as goodwill and patents. Emphasis is placed on tangible assets such as cash, inventory, equipment and real estate. Book value continually changes and it is advisable to update the business valuation often.

Capitalization of earnings
Value is estimated by establishing a reasonable rate of return on a purchaser’s investment. This is done by calculating the average net earnings after operating expenses over a given period of time and adding a rate of return (typically 20% for a small, private business). Where businesses have substantial inventory, real property, equipment and high receivables, an excess earning method is used to separate the rate of return from the company’s total earnings. The “excess earning” is multiplied by a factor and added to the fair market value of tangible assets to determine a purchase price.

Discounted cash flow
A discounted cash flow method is used to value a business based on future cash flow. This method adjusts earnings for non-cash expenses such as amortization and depreciation, and subtracts for future liability payments and potential capital expenditures such as the purchase of new equipment to project future cash flow over a period of time. An estimated discount rate over the term is calculated based on present value to establish a purchase price.

Sales-multiple valuation
Most often used to value a service business with few tangible assets, this method utilizes an accepted industry-specific multiplier applied to an average revenue stream over a given period of time (the longer the better). The weaknesses of this method are that multiplier considers only the average performance in the business’s industry and does not consider the business’s unqiue strengths or weaknesses.


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• Buy-Sell Planning
Most people who start a business do so with unbridled energy toward building their businesses, not thinking about what it will take to leave their business. In fact, when you consider that of the roughly 28 million small businesses in America, only a small fraction have taken the time to plan for a time when they or a partner will leave the company due to retirement, disability or death. Often referred to as an “exit strategy”, a written plan that takes these events into consideration will not only ensure that you have a way out that will pay you a fair value for having built the business, but will go a long way to ensuring that the company you worked hard to build survives after you’re gone.

One of the first and most important steps you should take when you start a business is to sit with any other owners as well as your legal and accounting advisors to create a Buy-Sell Agreement. Regardless of whether you are just starting out or have been in business for a number of years, if you don’t have a Buy-Sell Agreement in place, you should.

Next, you should decide whether using an LLC or separate partnership to own the buy-sell insurance policies is right for your circumstances (discuss with your legal advisor). If so, keeping insurance policies in an LLC or partnership could reduce or eliminate tax and requires only one policy per owner when setting up a cross-purchase Buy-Sell Agreement.

Buy-sell planning is critical for business owners, but many get busy with the day-to-day tasks of running their businesses and don’t follow up to do it. A word to the wise: Don’t wait until a dispute arises, a partner becomes disabled and is no longer contributing, or an owner dies, to learn the value of having a solid, written business succession and continuation plan in place.


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• Buy-Sell Restrictions
Restrictive clauses within a Buy-Sell Agreement can help protect your interests in the business as well as those of your family, your business partners and their families. These clauses will place restrictions on each owner’s ability to sell, give or bequeath their share of the business to anyone outside of the owners group (at the time that the agreement is executed) without prior permission and majority approval. This is designed to legally protect the interests of the business (business continuity) as well as protecting the owners from being forced to accept a family member or an outsider as a partner.

Consider the following questions when you meet with your estate planning advisor. Your BCG business succession and continuation consultant can provide vast knowledge in all areas of estate planning and Buy-Sell Agreement planning and execution.


• What is the value of the business and the value of each owner’s share?
• How will the value of the business be adjusted if an owner leaves—what value does he/she add?
• Should this agreement supersede all other agreements?
• Should this agreement apply to all owners for the life of the company?
• What special considerations should be understood between the owners?
• Should the agreement restrict the seller to selling only to current owners?
• Should a disabled owner be required to sell their interest in the business? How long will an owner be disabled before he/she must sell?
• Should the death of an owner trigger an automatic buyout of the deceased owner’s share of the business?
• Should the agreement allow a spouse or family member of a deceased owner to enter the business?
• Should the agreement require an owner who leaves the business (or dies) to sell to the remaining owners and remaining owners to buy from the seller?
• Should the owners who remain with the company have the first right of refusal to purchase the business share of an owner who wishes to leave (or dies)?
• What will happen to any loans that the company made to an owner who has died?
• How will loans made to an owner who leaves the company or dies be handled to the satisfaction of the remaining owners?
• What will happen if an owner files for personal bankruptcy? Will he/she stay with the business or be bought out? Will her/his role and/or ownership percentage change?
• What restrictions should be placed on owners to protect the business i.e., non-compete, geographic, other outside business interests?
• What types of restrictions should be made on owner salaries and distributions and under what conditions?
• How will Buy-Sell Agreements be paid for—personal or company-paid?
• Should a cross-purchase agreement be funded by insurance or company funds?
• What type of insurance is best to use for Buy-Sell Agreements, term, permanent, last-to-die?
• Should insurance policies be placed in an LLC or additional partnerships to potentially reduce tax?

Next Steps
If you are planning a business or have been in business for some time and do not have written Buy-Sell Agreements in place;


• Talk to your accounting and tax advisor
• Talk to your legal advisor
• Talk to your BCG business succession and continuation consultant


• First Right of Refusal
Incorporating a first right of refusal clause, also called a “shot-gun clause” into your Buy-Sell Agreement provides a means for an owner to sell his/her interest in the business if his/her partners are not interested or the company is not in a position to afford the buy-out.

Including a first right of refusal is smart if all of the owners agree that they want to ensure that they will have a way to sell their interest in the business. The Buy-Sell Agreement would typically limit the sale of any owner’s share only to the other owners. But what would happen if an owner wanted to retire or exit the business and the other owners refused to purchase his/her shares? This type of restriction might be too stringent. A first right of refusal clause opens the door to allowing an owner to sell his/her share of the business after first offering her share of the business for sale in good faith to the other owners and they have refused or are unable to purchase her share. Upon the refusal of the other owners he/she is free to sell his/her share of the business to a third party at the same price or higher as offered to the other owners, but not at a lower price.

Contact a BCG business succession and continuation expert to learn more about designing a Buy-Sell Agreement that works best for your business model.


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• Purchase Funding Options
The majority of Buy-Sell Agreement purchases are funded by life insurance for the following reasons:


• Many upstart businesses are underfunded and the business would not be able to afford a buy-out
• Most business owners see themselves only leaving the company if they die
• Life insurance provides immediate cash upon the death of the insured partner
• Life insurance can offer substantial tax savings to the company and the deceased’s estate/heirs
• Life insurance offers cost flexibility (term, permanent)

Life Insurance
Employing life insurance policies make it possible to affordably pay out the full value of a deceased owner’s value on an immediate basis and at full market value and gives owners a way to recover what they pay out if an partner retires. Securing insurance as a source of funding for a Buy-Sell Agreement demonstrates sound management to lenders and creditors, making alternate funding easier to obtain. Using life insurance also help a business to control cash flow since the premium payments are a set amount paid on a regular payment schedule.

Of course, not every business owner leaves his company by dying. A well designed Buy-Sell Agreement will consider the potential for an owner to leave his company because of disability, retirement, he/she wants to undertake a new and different challenge, or because she/he no longer gets along with the other owners. A strong Buy-Sell Agreement will incorporate multiple ways of funding a purchase of owners’ shares including:

Working Capital
Depending on the size and profitability of the company, and on the value of a departing owner’s share that is to be purchased, the purchase may be accommodated using available capital or paid in installments over a set period of time as agreed to in the Buy-Sell Agreement. The agreement would define clearly what triggering events would allow or require this type of funding.

Cash Sinking Fund
A Buy-Sell sinking fund is a cash account into which the business makes regular deposits of money to build up a fund sufficient to purchase the shares of a departing owner or to pay the estate/heirs of an owner who dies. Sinking funds work well if there is sufficient time to save and if the company is able to set aside substantial amounts of money in a relatively short period of time. In practicality, sinking funds are a risky way to plan for a Buy-Sell purchase.


• An owner might die well before sufficient assets have been accumulated
• The value of the business and thus each owner’s share value could escalate beyond the value of the sinking fund
• A pay-out could take place just as the company needs large amounts of cash for expansion, bad debt, emergency funding or other use
• Cash flow demands on the business could prevent deposits from being made into the account
• All assets in the sinking fund are subject to claims by creditors
• The money in sinking fund might not be invested properly and could lose substantial value or might be invested too conservatively and fail to keep pace with inflation

Borrowing
Borrowing to purchase an exiting owner’s share of the business can be fairly straight forward and simple. If the company has a strong credit history and meets the lenders requirements, Borrowing can be a good solution. However, since companies seldom know when an owner might die or wish to leave the company, it can be hard to be certain that the business will meet the lender’s criteria at the time the funds are required. The lack of credit worthiness, the loss of a key owner, a negative change in operating funds, a sudden increase in cash flow demands all could result in a loan refusal or dramatic increases in the terms of the loan, leaving the company in a bind for money to buy out the owner or pay his/her heirs.

Installment Payouts
Utilizing an installment plan to buy out an exiting owner’s interest helps to amortize the cost over a long period of time that is agreed to in advance by all owners. The longer the term of the payments the greater the amount that must be paid since the owner must wait for a longer period to collect his/her full share and also runs the risk of default. Still, if the selling owner were to die during the payment period, final payment terms to her/his heirs must be considered.


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• Insured Disability Buy-Sell Plan
Disability Buy-Sell planning helps ensure that the company will not be over burdened by the disability of an owner and that some provision is made to the disabled owner and his/her family. While creating their Buy-Sell Agreement, the owners would determine the relative value of each owner’s contribution to the business, determine criteria (along with their insurance professional) for triggering a buyout of the disabled owner’s interest, and determine the best means for funding the buyout.

Disability Buy-Sell insurance is designed to provide a means of purchasing the disabled owner’s share of the business after some period of disablement that has been mutually agreed to by all owners within the written Buy-Sell Agreement. Disability Buy-Sell insurance would be triggered only in the event that the insured owner becomes totally disabled.

Disability Buy-Sell insurance is different than disability insurance which is designed to offset a portion of a disabled worker’s income and varies based on the severity of the disability. An owner would likely carry standard disability insurance in addition to Disability Buy-Sell insurance.


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• Business Liquidation Insurance
If liquidation is forced on a disabled business owner or on the executor of a deceased business owner, it can quickly become public knowledge that there is pressure to dispose of the business, and these results can be anticipated:


• Sale of business assets at greatly reduced prices.
• Elimination of the disabled business owner's or surviving family's primary source of income.
• Sacrifice of any goodwill value that might have facilitated sale of the business as a going concern.
• Difficulty in collecting accounts receivable.
• Immediate demand by creditors for settlement of their claims.
• Possible liquidation of other estate assets to pay business debts.
• The liquidation value of a business is unpredictable and may be substantially less than the value of the business as a going concern.

Only life insurance can guarantee that the cash needed to avoid a forced liquidation will be available exactly when needed -- at the business owner's death (guarantee is based on the continued claims paying ability of the insurer).

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