If you and your spouse die without a formal guardianship plan for your kids, the state decides who raises them. If you become incapacitated without an advance health care directive, a judge chooses someone to make your medical decisions for you. Likewise, if you and I own a bookstore together and I die tomorrow, the courts will calculate how my percentage will be distributed unless we put a succession plan in place today.
You have no doubt heard the expression “not making a decision is a decision.” When I am talking to a client who is a partner in a successful business venture, I like to modify the saying in this manner: “Not having a plan is a plan … and not a very good one.”
This is particularly true for a small business when one of the partners can no longer fulfill their role because of death, incapacity, or an opportunity to explore their passion for painting in the south of France. Thousands of laws and legal precedents could determine who owns how much of the business if she and her other colleagues haven’t done the groundwork necessary to assure a smooth transition. If they don’t plan adequately, they’ll be left at the mercy of the system.
Since entrepreneurs rarely like the government dictating their behavior, it amazes me how few craft buy-sell agreements. At some point, the ownership structure of your successful dental practice or tattoo parlor is bound to change. When this happens, your business will be affected. Fortunately, your ability to control the outcome can be greatly enhanced by careful planning.
An effective buy-sell agreement covers how and to whom a partner’s ownership interest can be sold and describes how that ownership interest will be valued. The agreement also maps out what will happen when various triggering events occur, e.g., the death, incapacity, retirement, termination, divorce, or bankruptcy of an owner. Agreements generally have three parts: valuation, structure, and financing.
There are many ways a business can be valued — and ample opportunity for competing agendas if the methodology isn’t clearly spelled out. If a company’s founding partner dies, her spouse’s need to grieve for six months may outweigh any interest he or she has in the future of the partnership. In this scenario, the spouse would prefer a valuation method that affords a higher buyout, while the remaining partners want a valuation method that minimizes the buyout. This conflict can be avoided by agreeing upon a suitable valuation methodology at the beginning of the partnership and documenting it in a buy-sell agreement long before disaster strikes.
Determining the agreement’s structure can be even more challenging. This has tax consequences for both the family of the departed owner and the remaining partners. The potential for the greatest tax benefits accrues to a “cross-purchase agreement,” but “stock-redemption agreements” are simpler. In a cross-purchase agreement, each partner buys insurance on the other partners. If a partner dies, the insurance buys out his share. The fewer the partners, and the more similar they are in age and health, the more likely this will work.
With a stock-redemption agreement, the corporation bears the cost of the insurance policies. A big disadvantage of stock-redemption agreements is that the value of the surviving partners’ shares will be calculated using the value on the date the partnership was established, not on the date their partner left. As a result, should any partner leave the partnership prior to death, the remaining partners’ capital gains taxes will be higher than if they had bought out a departing partner under a cross-purchase agreement.
After the questions of valuation and structure are determined, the partnership should decide how to finance the buy-sell agreement. It may be possible to “self-finance” the agreement. Self-financing means the company will pay the pre-determined valuation price out of cash flow or borrow the money for the buyout and pay it off over time. This is only suitable for a profitable enterprise.
Another financing option is to purchase cash-value life insurance policies for the partners. In the event of a partner’s incapacity, retirement, or termination, the cash value of the insurance can be used to fund the entire buyout, or it can be used as a down payment. In the event of a partner’s death, the life insurance proceeds would be used to fund the buyout.
Buy-sell agreements usually aren’t expensive, but crafting one should be given the time and attention it deserves. Hire a knowledgeable attorney, and don’t just discuss the business aspects with your partners. Often spouses must sign such agreements, as they may be considered owners even if they don’t participate in the enterprise. Couples should talk to their financial advisors and attorney to understand how the different elements of such an agreement relate to their finances.
You have to work hard to build a successful business. Before you decide not to make a decision about putting together a buy-sell agreement, think again. Not having a plan may be a plan, but you, your partners, your family, and your business deserve better.