What you have to have in place.
By Ed Mendlowitz
77 Ways to Wow!
Not having a buy-sell agreement doesn’t mean anything unless a co-owner dies, becomes disabled, becomes bankrupt, divorced, wants to quit, retire or many other things. I regularly receive calls from accountants on behalf of clients who need valuations because a co-owner had died suddenly without a buy-sell agreement.
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Here is a bleak picture of what happens and what can be avoided. The scenario: A business owned by two friends who started it 20 years earlier. They’re pretty successful, they make good livings, fund their pension plans, and they have money left over each year to provide for modest growth. But they haven’t accumulated any extra savings and they still have home mortgages and kids in college. They are both 50. And then one dies suddenly. The survivor must buy the interest from the estate of his deceased partner. But he doesn’t know what to offer and can’t afford too much.
Now, the problems and costs begin.
The business accountant is asked to determine what the widow should be offered, and he comes up with a reasonable amount. But the survivor doesn’t know how he could manage the payments unless they could be spread over five or six years. This must be discussed with the widow. But first, the survivor needs to make sure the business stays on track.
Checklist: Eight Things to Deal with Right Away
- His hours jumped up and included the need to start earlier and go home later.
- He must hire someone to replace some of the work the partner was doing.
- He must find out all the nitty-gritty his partner was doing and start doing it.
- Customers need to be contacted that business will be as usual.
- Some of the employee responsibilities need to be shifted and more time needs to be spent managing the staff.
- He must assure suppliers of the continued viability of the business.
- He must meet with the bankers to comfort them.
- He will also need to spend time with the accountant to discuss cash flow.
Now, the survivor finally meets with the widow, who tells him she hired an attorney to advise her, and she will leave the buyout to the attorney, the one who “understands how these things work.”
Her attorney questions the ability of the accountant to value the business and his objectivity. The attorney tells the widow that she would need a valuation prepared by an independent business appraiser that she could refer.
Comment: It would not be responsible for the attorney to advise her client without the valuation. However, this is a costly and time-consuming process, and the attorney says they will also need to engage an accountant to audit the books or, minimally, oversee the business to make sure funds are not being diverted. The attorney says, “It is my responsibility as your attorney.” And you know what? The attorney is right.
Meanwhile, whatever valuation amount is concluded, it will likely be much more than the survivor could manage. So, the survivor will need to engage his own attorney and another appraiser to rebut the first one. This process will drag on at least six months and likely longer. Also, the relationship between the two families has deteriorated and they would no longer speak. A 20-year friendship is down the drain along with at least $25,000 of costs and a declining business with doubt as to its continuity.
If there were a buy-sell agreement, the price and terms would be clear, likely manageable and none of the time dealing with the attorneys and accountants would have been needed to be spent along with the extra fees. Also, the time would have been devoted to keeping the business going.
Buy-Sell Agreement Drop-Dead Plan
Any business with more than one owner – a corporation, partnership or limited liability company – must have a shareholders, partnership or members agreement. Such an agreement is a “will” for a business.
Imagine the complications, problems, issues and controversies that arise when a part-owner dies and there is no such agreement. Other issues arise when an owner becomes disabled or imprisoned, files personal bankruptcy or goes through marriage dissolution. All of these circumstances should be addressed.
Another issue that can be covered is when an owner wants to retire or leave the business. These are two different situations. Someone may want to go to work elsewhere or start a competing business while a retiring partner usually won’t.
That being said, when understanding that there are many different variations of such agreement, three issues should be determined:
- The trigger points – what causes the buyout to become effective
- The valuation – what price will be paid
- Payment terms – over how long a period will the payments be made
The co-owners need to keep in mind that they could be on either side of the future transaction, and without an agreement, they may leave a mess for their partners and family.
I believe it’s best to have a comprehensive plan and agreement. Getting everything ironed out early on in the relationship is important and gets this “chore” put aside.
However, many business owners have difficulty making decisions regarding the “split-up” of their business, which is what occurs when one of the owners makes the decision to leave. So, the agreement never gets completed.
Buy-Sell Agreement Default Plan
I have a default plan suggestion for people who can’t or won’t make the decisions needed for a complete agreement rather than continuing with no agreement. The plan involves getting something in place if there is an untimely death or disability with the other issues considered at a later date. Ideally, there should be a complete agreement, but covering these two potentially solves a lot of problems, and limiting it makes it easier to get something done.
A suggested default valuation for the buy-sell agreement is to use the current “fair market value” or other agreed-upon basis for valuing the company with future annual adjustments for increases or decreases in book value. Payments should be made over a five- to 10-year period with interest at the then-current applicable federal interest rate.
In a worst-case scenario, a new valuation should be obtained every five years. Ideally there should be a new valuation every two years. One further adjustment would be if the business is sold for a greater price within one year after the buy-sell transaction takes place. In that situation, the buy-sell value would be adjusted to a pro rata portion of the actual sale price and the payment terms would be consistent with the terms of that sale. There will be no downward adjustment.
Buy-sell agreement valuations concern the IRS, where low values are routinely scrutinized to make sure there isn’t a gift element in the transfer. However, while the IRS looks at the values and compares them to “fair market value,” that is not necessarily the proper standard because the valuations are not for cash payment and there are other elements removing it from FMV such as a necessity to sell and buy because of the trigger event causing the sale. This is a discussion for another time, but the main issue here is to protect the company and the deceased owner’s family, and that makes executing such an agreement a must.
Death and disability are also two situations that can be insured against, in most cases. Life and disability buyout insurance can be looked into while you are having the agreements prepared.
Valuation for “Drop-Dead” Buy-Sell Agreement
Here’s another approach to the “drop-dead” plan that can be considered. These methods are suggestions to get something done, so there will be no unnecessary problems if there’s a premature death or unexpected disability. And aren’t almost all deaths premature, as are most disabilities? The best way to deal with them is to make provisions so there won’t be any unnecessary uncertainty.
The big picture, and urgency, is the necessity of getting an agreement that covers death and disability of the co-owners. For that, a payment amount and terms need to be agreed to (understanding that either party could be on either end).
To accomplish this, you need to arrive at a number that both parties think is reasonable. Not a number they would sell the business for, to value a transfer to a successor or family member, to fund a retirement, or for the myriad other reasons stock would be transferred. The purpose of this agreement is to avoid conflicts between the remaining owners and the family of the deceased or disabled owner and to allow the remaining owners a reasonable way to make the payments.
A simple method is for the partners to agree on an amount and terms they would be willing and able to pay and would feel comfortable for their family receiving.
A second way is for the clients to work with their CPA, attorney or a valuation specialist to assist in the determination of the amount, terms and location of the cash flow payments. Keeping in mind the limited purpose of the agreement, this could be done relatively easily. Their attorney should prepare the actual buy-sell agreement.
To accomplish this, I don’t think you need a formal conclusion of value. If the transfer is between relatives, a gift element or a tax-based transaction, you would need a conclusion of value for the fair market value prepared in accordance with IRS rulings and requirements … but that is a different situation than I am discussing here. If for some reason the IRS challenges the value, you can get a formal valuation then. But it would have no effect on the buy-sell transaction between the parties. You can also add (to the amount paid) that an adjustment would be made if there is a sale to a third party at a greater price within one year after the buy-sell transaction.
I have seen too many situations in which an owner died or became permanently disabled and problems arose, along with excess costs that could have been avoided if they had signed a buy-sell agreement.
Make your clients’ lives less complicated, and reduce stress and consternation. Get it done! For their sake.
