Don’t Do Business Without This Agreement!

The business continuity agreement can be one of the single most important documents that you, as a co-owner of a closely held business, will sign. The following Acme In-Law hypothetical case study illustrates the importance of a well-crafted buy-sell or business continuity agreement.

George Acme well-appreciated his son-in-law, Tom Gardner. Tom had been with the company for over 20 years, had gradually assumed operational management and was the acting CEO. He had purchased 25 percent of the ownership from George over the years – mostly at a low value in recognition of his valuable services. Eventually, everyone knew that Tom would own the company and carry on the fine traditions of Acme. But that was before George died and Tom’s sister-in-law became the executor of the estate. She was happy to sell the balance of the company – but at full fair market value and in cash – or she would sell the business to the highest bidder. Only later would she realize that without Tom’s cooperation, the business was unlikely to sell – no buyer would want a disgruntled minority co-owner, especially the current CEO. Both owners had issues with value, control and successor ownership – issues best discussed and resolved before a transfer event such as a death or a sale opportunity arises. Had Tom and George acted on a timely basis and created a business continuity agreement, the business would have transferred at a fair price to the benefit of all concerned. Now, it likely wouldn’t continue at all.

The business continuity agreement (also called a buy-sell agreement) controls the transfer of ownership in a business when certain events occur. Typically these events include the death of an owner, and a sale and transfer of stock from one owner to another or to an outside party. In addition to controlling these events, you also should consider having the agreement include transfers to take effect upon an owner’s permanent and total disability, termination of employment, retirement, bankruptcy, divorce, and a business dispute among the owners.

At each of these events, the business continuity agreement may require the business or the remaining owners to purchase the departing owner’s stock; or it may give an option to the business or the remaining owners to buy that ownership interest. Lastly, it may give the departing owner the option to require the company to buy his or her ownership interest.

The agreement also should establish the value of the stock, set the terms and conditions of the buyout, and give additional protection to all owners. In short, the business continuity agreement, in addition to other protection, tells you to whom you can sell, at what price and terms, and under what restrictions you can sell your stock. Upcoming articles will discuss these restrictions, as well as identify the advantages of the buy-sell agreement.

Advantages of a Buy-Sell Agreement

With buy-sell agreements, disadvantages can be hard to find if the document is well-drafted and is kept updated for changes in ownership, value and other circumstances. With that in mind, we will look at the overall features that owners can experience with buy-sell agreements.

• Ownership in the business can be transferred only in accordance with the agreement. This benefits both the owner wishing to transfer stock and the other owner or owners wanting to acquire stock. In the first instance, the buy-sell agreement can assure a selling shareholder, or his/her estate, of a purchaser for fair value and upon terms and conditions that are mutually acceptable. For the remaining owners (such as Tom), the agreement means that any transfers of ownership must be made, or as least offered, to them. This eliminates the threat that an outside party or a co-owner’s spouse or children will become owners of the business, thereby diminishing management, control and value.
• Valuation is set not only for purposes of a sale, but also for estate tax valuation purposes. Privately owned businesses are notoriously difficult to value. Your idea of your business’s value at your depth may be much lower than the IRS’s. If you haven’t created a binding process for valuing the business, the IRS is free to impose its own value determination. Take the initiative by designing a valuation appraisal process in your buy-sell agreement.
• The terms and conditions of any transfer of stock, including interest rate, length of buyout period and security, can be fixed. In addition, where possible, the transfer can be funded. The agreement provides a clear picture to a departing shareholder of how much money he or she will receive and how often. Likewise, the remaining shareholders know in advance the extent and duration of their buyout obligations. This allows both parties to plan their respective futures.

Had Tom and George created an agreement providing for terms such as these, a valuable business would have been transferred to the benefit of all owners, as well as the employees, customers and others having an interest in seeing Acme continue.

As we have discussed above, there can be many advantages to a buy-sell agreement in regard to establishing transfer of ownership, valuation techniques, and terms and conditions. In the next Exit Planning Navigator® articles, we will continue looking at the features of buy-sell agreements and identify some of the common scenarios in which buy-sell agreements can be most effective.

If you have any questions about establishing strong business continuity agreements and their role in helping you exit your business in style, please contact Kevin Short Managing Director (kshort@claytoncapitalpartners.com).

Subsequent issues of The Exit Planning Navigator® discuss all aspects of Exit Planning. If you have questions, please contact Kevin Short, Managing Director (kshort@claytoncapitalpartners.com).

1 Feldman, Dr. Stanley J. and Winsby, Roger, “Financial Service Needs of Established Business Owners: The Size and Demographics of a Wealthy Underserved Market,” Axiom Valuation Solutions, formerly bizownerHQ.

2 Canadian Federation of Independent Business (CFIB), “Is Your Business Worth What You Think It Is?” Deloitte & Touche LLP - Canada (English), Posted June 25, 2006.

3 Pricewaterhouse Coopers, “Trendsetter Barometer,” released January 31, 2005.

4 The Wall Street Journal, “The Retirement Lies We Tell Ourselves,” December 11, 2006.