Closely held businesses with more than one owner are generally advised to implement buy-sell agreements to provide for an orderly buyout after a “triggering event,” such as an owner’s death, disability, divorce or withdrawal from the business. Does your buy-sell cover all the bases? Is it up-to-date? You can’t afford to ignore these important questions!

The Basics

Buy-sell agreements establish guidelines for the transfer of ownership interests. These contracts give the remaining owners (or the business itself) the right (or responsibility) to buy a departing owner’s interest. They describe when and to whom business interests can be sold.

Buy-sell agreements also address how the price of the owner’s interest will be determined. Ironing out these details before a triggering event happens can help resolve matters quickly and minimize disputes between the owners.

Valuation Provisions

A fundamental element of executing a buy-sell agreement is determining the value of the departing owner’s interest. There are many mechanisms for valuing business interests in an agreement.

The simplest is for the owners to negotiate a fixed price when drafting the agreement — before they know whether they’ll be the buyer or the seller of an interest. Of course, the downside to this approach is that the value of the business is likely to change over time. If the buy-sell agreement isn’t updated regularly to reflect current conditions, the prescribed buyout price could rightly be contested.

To remedy this, some agreements call for the owners to agree on a valuation formula to determine the buyout price of the departing owner’s interest. For example, you might use book value (from the company’s balance sheet). Or you might apply an industry rule-of-thumb based on the prior year’s revenue or earnings before interest, tax, depreciation and amortization (EBITDA). This approach allows the value of a departing owner’s interest to change as the business expands (or contracts). But the downside is that these formulas tend to be oversimplified and may not be relevant years later when a triggering event happens.

A more reliable approach may be to obtain a formal valuation of the departing owner’s interest from an independent business valuation professional. If you choose this route, it’s important to specify key details, including:

• The appropriate valuation date,
• Who pays the valuator’s fees, and
• Whether discounts for lack of control and marketability apply.

The application of valuation discounts can be a major point of contention. For example, suppose one person owns 75% of a company’s stock and the rest of the shares are split equally between five other individuals. If one of the 5% owners decides to leave the company, should that person receive 5% of the company’s entire value — or should the interest be discounted to reflect the owner’s inability to control day-to-day business operations (lack of control) and the time and costs of selling the interest (lack of marketability)?

Warning: The value of your business may have changed from the effects of the COVID-19 pandemic and the ensuing economic changes. Review the valuation provision of your agreement to ensure that you’ll receive (or pay) a fair price.

Funding Options

When you have an idea how much the business is worth, you can anticipate how much money will be required to buy out an owner’s interest.

Buyouts are typically funded by life insurance. These policies may be purchased by the company, individual owners or special entities set up for this purpose. When a buy-sell agreement is triggered by the death of an owner, death benefits from the policies are paid to the decreased owner’s family members to purchase the business interest. It’s important to periodically evaluate whether policies still provide adequate coverage to fund a buyout.

Life insurance isn’t limited to buyouts of deceased owners’ interests, however. The cash surrender value of whole life policies can also be used to purchase a business interest if an owner retires, becomes disabled or otherwise decides to leave the business.

Absent life insurance, buyouts may be funded by a company’s cash reserves, its operating cash flows or bank loans. Some agreements call for installment sales to spread out the payments over several years. This can also help alleviate the departing owner’s tax burden. If you expect to use installment payments, it’s important to address this upfront in your buy-sell agreement.

Don’t Let Ownership Shake-Ups Disrupt Your Business

A buy-sell agreement is a critical component of risk management and succession planning. In today’s uncertain markets, you may need to update your company’s agreement — or to establish one if you haven’t done so already. Contact us for more information on how to structure a buy-sell that’s right for your business.