By Michael Torney, J.D., CFP®, LL.M., CEPA
When people start a company, it’s impossible to predict events that could affect it 10 or 15 years in the future. But after working together many years to build a successful company, what happens if one of the owners is suddenly divorced? Or two joint partners fundamentally disagree on significant issues? Or one owner becomes permanently disabled?
To prevent these situations, the owners of many companies sign a buy-sell agreement. The agreement is a legal contract that ensures a smooth transition of ownership and continuity of operations in the case of a major event that affects the lives of the owners.
What is a Buy-Sell Agreement and What Should It Cover?
A buy-sell agreement is recommended for any business that has multiple owners, even in its early stages.
To draft the agreement, all of the owners should meet to address several major issues. These issues include the following D’s: Divorce, Disability, Disagreement, and Death.
The agreement captures detailed information about how a partner’s shares in the business will be reassigned if one of these events occurs. Most often, it stipulates that this owner’s shares are sold to the remaining partners or to the partnership.
In addition to transferring shares to the other owners, a buy-sell agreement accomplishes other important goals. Among the most important: it establishes a fair market value of the business and decides how the company must fund its agreement. It also can lay out how the company will handle potentially thorny issues, such as firing a shareholder or how to respond to any offer to buy the company.
A buy-sell agreement is not an entire succession plan. However, it is part of a well thought out succession plan. While a succession plan provides an orderly transition when one or more of the owners is planning to leave the business, the buy-sell agreement protects the business if an unfavorable, unexpected event occurs. It is there to help protect the business from being thrown into chaos.
What Events Trigger a Buy-Sell Agreement
A major event must happen to one of the owners to trigger a buy-sell agreement. The most common events that trigger a buy-sell agreement include: Divorce, Disability, Disagreement, and Death.
The Most Common Trigger – Divorce
While many people see buy-sell agreements as a way to protect against one owner’s sudden death, data shows it’s more likely that one of the owners will experience a divorce.
According to the American Psychological Association, approximately 40-50% of first marriages end in divorce. The divorce rate for second marriages is even higher, with approximately 60-67% of second marriages ending in divorce.
No owner wants someone who has little knowledge of their company to become a part-owner of their company. A buy-sell agreement can prevent this from happening by including provisions that detail how ownership is transferred to the company in the event of a divorce. These provisions are extremely important in community property states where the ownership in a business is treated as joint marital property.
Here’s a good example of how the agreement can protect the owners:
Two men, Joe and John, are partners who own a business. Each person owns 50% and the business is valued at $5 million.
Years after forming the business, Joe becomes divorced. Fortunately, he and John signed a buy-sell agreement that includes provisions for this event. The agreement says that if one of the partners becomes divorced, the other partner has a right to buy the share of the partner that would otherwise pass to the divorcing ex-spouse.
The agreement specifies how a price is to be determined for the purchase, making certain there is no dispute about the price.
Disability
A buy-sell agreement may also be triggered by the onset of a physical disability in one of the owners.
For example, an owner who is diagnosed with a major disease could need medical treatment over several months – possibly longer – before regaining their ability to work full-time. They may not be able to work regularly and will lack the energy to carry out their responsibilities. If the affected owner manages several people or is the lead sales person, the other owners may need to invoke the buy-sell agreement.
Many companies purchase disability insurance as part of their buy-sell agreement. This policy allows the company to continue paying the affected owner’s salary while they are out of work or completely buy out their shares if the disability is permanent.
Disagreement
Successful businesses often rely on multiple parties each fulfilling a distinct value added role to the business. Bringing people of different skill sets, and often values, into close proximity often results in conflict. Often these issues can be solved through effective communication and other problem-solving techniques. When these issues cannot be solved, a buy-sell agreement can be used as a last resort.
Death
What would occur to an owner’s business if they died today? Often, there is not liquidity to pay the business owner’s family for the value of the business. Worse, the owner’s family is not involved in the business and cannot step into the owner’s previous role. Death of an owner can be very problematic if left unmanaged, but is one of the easier problems to solve. Adding a death provision into a buy-sell agreement and funding that agreement with life insurance can ensure the owner’s family is set up for financial success. An owner may also want to plan for how the business’s long-time employees will be set up to run the business after their death.
If you have questions or would like to discuss creating or updating your buy-sell agreements, feel free to contact me at Mtorney@monetagroup.com. We offer a free consultation to help owners better understand the financial issues impacting their business.
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