The Bottom Line: Updating A Shop’s Buy-Sell Agreements
As owners contemplate exiting their businesses, they need to look at their specific circumstances and understand that there is no standard exit-platform that fits every business.
As owners contemplate exiting their businesses, they need to look at their specific circumstances and understand that there is no standard exit-platform that fits every business. Owners need to consider their plans for the company, the direction that the industry is headed and consider unpredictable events. As these facts change with time, the operating agreements must adopt the changes as well. Having the right documentation in place ensures that a company has a strategic start to a succession plan.
The first step is to review the current operating agreement to make sure it outlines a buy/sell agreement. Business owners young and old should consider how to exit the company (voluntarily or involuntarily). In addition to retirement, these agreements should protect every owner from the potential death, divorce or incapacity of the other owners.
The first step to developing a strategic succession plan is the right documentation.
Consider that two best friends start a mold shop. They put in their sweat-equity and now the company is making nice profits. The ownership agreement states that each friend owns 50 percent of the company. Then an unforeseen event occurs leaving one business partner incapacitated. According to his estate plan, all of his assets turn over to his life estate, in which his wife is the trustee and management decision maker. In the blink of an eye, one of the 50-percent owners is now his wife, who has no previous experience in tooling or operations management. She may not have interest in being an owner, but unfortunately her spouse did not have adequate life insurance. Now she is looking to the company to be able to sustain her family’s lifestyle. Suddenly, legal is taking up most of the company resources, which could continue for a few years because the agreement did not include what to do next. If the operating agreement of a company does not have a buy/sell agreement in place, this path is a real possibility. Implementing or updating a buy/sell agreement through a company’s operating agreement is one of the most important pieces of a succession plan.
Buy/sell agreements serve multiple purposes in one document, including identifying the person or people who can buy interest in the company, how to determine the transfer price of the ownership interest, how to structure the terms for the buyout and tax implications of the chosen structure. Here are some objectives to consider when creating or updating a buy/sell agreement.
Protecting remaining owners from being in business with an unqualified person. Once a specified incident occurs, other owners are typically given certain rights on purchasing the new owner’s interest. These rights help keep the departing owner’s spouse, children or appointed person of an estate from taking over the ownership. Often, decedents may take over a majority interest, so outlining who can buy the interest enables the remaining owners to determine the company’s best future ownership structure.
Making sure the purchase price criteria are outlined. A methodology for owners to determine the purchase price of a departing owner is something the owners should outline in the operating agreement. This governs the steps for determining the value. Formulas can facilitate obtaining fair value appraisals and can facilitate taking specific discounts and multiples into account, based on the industry. Some may be based on historical financial results, while others on the fair market value. It is good practice for the owners to review the formula every few years.
Ensuring that the purchase agreement is not going to strap the company or other owners for cash, while still providing for the financial needs of the departing owners or their heirs. A lump-sum buyout is not always feasible, so consideration of the buyout structure must be given to both the buyer and the seller. This prevents the company from sacrificing the cash that it needs to sustain operations. If the departing owner leaves behind a family that needs support, the terms should afford the heirs the means necessary to maintain their standard of living. Payouts over a term of years is typical, but each agreement should consider company cash flows for payments, and perhaps reserve the rights to skip principal payments during low cash-flow periods.
Reviewing the tax implications of the company structure along with the business structure. When it comes to buying and selling assets and investments, there is always the underlying question of what the “net tax” will be for the cash received. Owners must consider the company structure and the payout terms. For example, if the company is a C-corporation and converts to an S-corporation, the company might still be subject to corporate tax implications. Also, depending on the structure of the buy/sell agreement, the IRS might view it as a taxable redemption, which results in taxable dividends. It might also be considered a stock sell, triggering gains in the company and then again on the stock held. Reviewing the possible implications to both parties and any modifications is vital.
Taking the right steps before the need for an exit plan arises will significantly improve the process, lessening the emotional aspect of what an owner must pay or what an owner will receive. It also will help owners avoid lawsuits, so business operations can continue without concern for any resulting financial impact.
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