Patching Holes Continued….

HOLE 4: IGNORING COMMON LIFETIME TRANSFER EVENTS

Buy-sell agreements often do two, and only two, things:

1. Provide transfer instructions upon the death or incapacitation of an owner.
2. Provide a right of first refusal to the remaining owner(s) when a co-owner wishes to sell his or her ownership interest to an outside party.

Oftentimes, buy-sell agreements do not address or are woefully suited to handle more-common lifetime transfer events, such as the following:

• Involuntary transfers caused by personal bankruptcy or divorce.
• Forced termination of an owner’s employment.
• Irreconcilable differences between owners.

The goal of a good buy-sell agreement is to assure that all owners are treated equitably. We encourage you to update your buy-sell agreements to achieve this goal before you need to. It’s much easier to negotiate terms level-headedly than to do so when emotions run hot. Let’s look at the implications of each of these common events.

Involuntary Transfers Caused by Bankruptcy or Divorce

In both of these events, an owner is forced to transfer ownership to either a creditor or an ex-spouse, respectively. Thus, buy-sell agreements should stipulate that when an owner finds him or herself in such a situation, the business (through co-owners or key employees) should have the right to acquire the owner’s interest.

In our experience, creditors and spouses often prefer cash to an illiquid ownership interest. While it’s possible that a creditor’s or ex-spouse’s lawyers will deem right-of-first-refusal stipulations in your buy-sell agreement unenforceable with respect to their clients’ rights, giving the company the option to purchase the owner’s interest will turn an illiquid asset (i.e., the company) into a highly liquid asset (i.e., cash), making the best of a bad situation.

Thus, the best way to patch this hole in your buy-sell agreement is to consult strong legal counsel, which is an integral piece of your Exit Planning Advisor Team, to assure that buy-sell provisions are enforceable and in the company’s best interest.

Forced Termination of an Owner’s Employment

For businesses with multiple owners—whether majority/minority or equal split—forced termination is rarely, if ever, considered in a buy-sell agreement. The complexities and inherent hostility in these situations imply that there is no boilerplate solution to this dilemma.

For example, controlling owners might want the ability to purchase a terminated owner’s interest. The fired owner may want the ability to sell his or her ownership back to the company or the other owners. All owners may simply want the agreement to require a mandatory purchase of ownership in the event of an owner’s employment termination for any reason.

It is important to consult an Exit Planning Advisor to assure that your buy-sell agreement addresses these acrimonious conditions. Determining a fair value of ownership interest, along with having specific buyout terms and conditions, can make a forced termination equitable for all owners involved.

Irreconcilable Differences Between Owners

Occasionally, two non-controlling (i.e., equal) owners will have a falling out for any number of reasons. Whether the owners disagree about the business’ future or otherwise, these fallings out are almost never covered under a buy-sell agreement, meaning that a particularly vindictive owner can bring business operations to a halt.

Patching this hole requires a provision in the buy-sell agreement that we call the “Texas Shootout Provision.” This provision is the buy-sell agreement’s nuclear option and is used when a disagreement has no alternative solution. The Texas Shootout Provision stipulates that either owner may offer to purchase the other owner’s interest.

The second owner must then either accept the offer and sell his or her ownership interest or purchase the first owner’s interest for the same price, terms, and conditions spelled out in the offer. Thus, the second owner has two choices: accept the offer and sell his or her ownership interest or turn the tables and buy the offering owner’s ownership interest.

The Texas Shootout Provision will leave the business with one owner in the end. We strongly encourage that you include it in your buy-sell agreement for two reasons: (1) It encourages the owners to come to an agreement in which one buys out the other before the provision is activated. (2) It prevents vindictive owners from stalling the sale process. Additionally, this provision allows for a third solution: If the owners absolutely cannot get along or come to an agreement, they can dissolve the business, sell the assets, and start over.

Patching the common lifetime–events hole will require you to hire a business attorney who is well versed in state law and can determine whether the provisions in your buy-sell agreement can be enforced. You must make sure that you hire the best of the best, because if push comes to shove, your co-owners will do the same.

HOLE 5: USING COOKIE-CUTTER VALUATION FORMULAS

Buy-sell agreements typically fall into the trap of using generic valuations when valuing the business for sale. The problem stems from confusion or misinterpretations related to the business’ likely value. Additionally, the cost of more-comprehensive valuations, such as an opinion of value from a credentialed appraiser, often causes business owners—even those who own companies worth millions—to balk at a valuation.

The key to patching this hole is to determine the goal of valuation in your buy-sell agreement in the context of your business’ maturity. For instance, while it may make sense for a small business that is 100% reliant on its owners for revenue to use a simple agreed-upon value, owners of a multimillion-dollar company would be remiss using such an inaccurate valuation method.

Likewise, a small company probably won’t need a full opinion of value (which can cost $15,000 or more) for its initial buy-sell valuation. The complexity of your company and your Exit Planning Objectives will determine which valuation method you use in your buy-sell agreement.

HOLE 6: OUTDATED BUY-SELLS

Many buy-sell agreements are drafted early in the business’ life and never reviewed again. As the business grows or changes, owners often neglect to update their buy-sell agreements in light of new business developments. Thus, when the time comes to transfer the business, many owners find provisions that no longer reflect the state of the business or their desires.

These buy-sell agreements often fail to manage transfers successfully because they are reflective of a business that no longer exists.

Your buy-sell agreement needs to be a reflection of your company’s current operating status. This is especially true for buy-sell agreements that include a valuation. As time passes and the business changes, valuations will change, and the farther away from the initial valuation you get, the less accurate the valuation becomes. This often leads to material unfairness between owners, which can lead to bitter, drawn-out litigation.

The patch for this hole is relatively simple: Include your buy-sell agreement in your annual fiscal year–end reviews. Updating your buy-sell yearly, with the help of a financial advisor or Exit Planning Advisor, will keep your company’s value and your Exit Objectives up-to-date. It will also reduce the likelihood of litigation between disagreeing owners.

HOLE 7: POORLY IMPLEMENTED BUY-SELLS

In addition to not reviewing their buy-sells, many owners fail to update their buy-sells in light of changes of ownership, changes to life insurance policies for owners, and other changes. Failing to amend provisions to reflect these changes can have the same prickly outcome as using an outdated buy-sell agreement.

The patch for this hole is to look both inside and outside of the buy-sell agreement for changes that can affect its efficacy. Certainly make sure that, during your buy-sell agreement reviews, you are reviewing the signed buy-sell agreement, not an unsigned draft. Updating and adjusting your buy-sell agreement can prevent acrimony between owners.

CONCLUSION

Many continuity plans are inadequate because they have at least one of the aforementioned holes. Because Exit Planning Advisors look at continuity plans and buy-sell agreements as parts of the owner’s overall Exit Objectives, we strongly believe that when triggered, they need to fulfill the goals of both the departing owner and the new owner. In our experience, a majority of continuity plans and buy-sells fail to do so.

Taking time to assure that your business-continuity plan, especially your buy-sell agreement, is comprehensive will allow you to rely on your plans with little worry. A continuity plan crafted in the context of Exit Planning will prepare you for just about any kind of exit, whether your exit is planned or unexpected. Please contact us today to begin creating a strong business-continuity plan for you, your family, and your company.

Content in this White Paper is for general information only and is not intended to provide specific advice or recommendation to any individual. Additionally, it is not to serve as a substitute for individualized tax and/or legal advice. If you have a concern regarding your specific situation, please discuss it with a qualified tax or legal advisor or contact us today.