30 Dec Buy-Sell Agreements

Buy-Sell Agreements

Most businesses will end at some point, which could happen for any number of reasons. A recent article in Forbes, in fact, states that 8 out of 10 businesses fail. Regardless of why a business may fail, the decision not to acknowledge this fact when starting a business is tantamount to burying one’s head in the sand.

For businesses that have more than one owner, an ideal way to address the potential failure of the business–or not necessarily the failure, but the simple fact of an exit strategy–is to draft a buy-sell agreement, which is most often drafted at the formation of the company. Understanding how buy-sell agreements work is also an important consideration when deciding whether to buy and sell a business.

This article outlines the three types of buy-sell agreements, and offers pros and cons as to each type.

What Is a Buy-Sell Agreement?

A buy-sell agreement is a contract between co-owners of a small business that explains what will happen upon the occurrence of certain trigger events, such as the death or disability of an owner; the decision of an owner to retire or leave the business; or a struggle between the owners for control of the company. It is a contractual exit plan between co-owners that is often created at the formation of the business, and it ensures that the business will continue to function despite the occurrence of any of these events.

If any of these events occur, it will be extremely difficult for co-owners to actually agree upon how to buy each other out, and how to do so at a fair price. This is because each owner will have his or her own self-interests and objectives, and there will often be many emotions involved in the case of a fallout between the owners (hatred, jealousy, anger–think of divorces) that did not exist when the company was started (it’s all roses and we’re going to be millionaires).

Different Types of Buy-Sell Agreements

There are three main types of buy-sell agreements, each of which may use an insurance policy (in the case of a death or disability) to fund the buy-out.

1) Cross-purchase agreements

Cross-purchase agreements provide for the purchase of the stock (or interests, if an LLC) of a withdrawing shareholder by the remaining shareholders.

Cross-purchase agreements are often funded with cross-owned life insurance policies. That is, each shareholder owns life insurance on every other shareholder in an amount that will fund a pro rata acquisition of stock on the death of a shareholder.

Example: A and B each own 50% of the shares of a company. A takes out a policy on B’s life, and B takes out a policy on A’s life. If B dies, the proceeds of the policy A took out on B’s life are used by A to purchase B’s shares, making A a 100% owner of the company. Or, the reverse could happen if A dies before B.

Pros:

The proceeds received by the surviving shareholders may not be subject to federal income tax.

Sellers (or their estate) likely will receive capital gains treatment on the proceeds of the sale.

They are ideal in situations where there are a limited number of shareholders who are approximately the same age and hold equivalent amounts of stock.

Cons:

They may not be economical (if a business is worth a lot) or even feasible, from a practical perspective (if there are many owners).

There may be disproportionate costs if there is a disparity in the ages or insurability of the shareholders and the coverages needed to fund the purchase of each of the policies.

2) Stock redemption agreements

Stock redemption agreements require that the company purchase the withdrawing owner’s shares upon the occurrence of the trigger event.

Like cross-purchase agreements, stock redemption agreements may be funded with life insurance, or with life insurance combined with installment payments. The company is the owner and beneficiary of the insurance policy.

Pros:

Simplicity: Only one policy will be needed, as opposed to cross purchase agreements. This is significant when there are more than two or three shareholders of differing ages or stock interests.

Cost: The company pays the policy premiums, so the shareholders are not burdened with this expense.

The policy is a company asset.

Cons:

The shareholders will not get a stepped-up basis, even though the value of their interests in the company will increase.

The insurance proceeds may result in a corporate alternative minimum tax.

3) Hybrid agreements

Most buy-sell agreements are hybrids of cross purchase and stock redemption agreements. In these situations, the company has the option to acquire the withdrawing shareholder’s stock. If it is unable or unwilling to acquire all of the stock, the remaining shareholders then have the option to do so.

Drafting Considerations

Buy-sell agreements usually require the assistance of an attorney (for drafting the agreement), an accountant (for advice on tax considerations) and an insurance agent (in cases where life insurance is purchased).

In drafting the agreement, you will generally want to include each the following terms:

– A restriction on transfers of the shares in the company;

– Rights of first refusal or an option to acquire the shares if a shareholder desires to transfer shares during his or her lifetime;

– Procedures as to the exact consequences of a shareholder’s death or retirement;

– Establishment of the purchase price or a method for determining the purchase price upon a triggering event. (This is often one of the most difficult terms to establish because small businesses are difficult to value. However, an appraisal may be used.);

– Terms for payment for purchase of the shares;

– A description of any required insurance coverage; and

– An explanation of the withdrawing/selling shareholder’s rights during the payment period.

If you are interested in drafting a buy-sell agreement for your Oregon business, want to learn more about such an agreement, or have other questions about buying and selling a business, please contact us.

Author: Andrew Harris

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