Abstract: When a business owner dies or leaves a company unexpectedly, disagreements among the remaining owners and outside parties pose a threat to its financial health and continued existence. A buy-sell agreement can help mitigate such risk by limiting ownership and control of the business to a select group. This article discusses valuation and funding issues, while a sidebar notes that a buy-sell agreement can provide liquidity to heirs.
Buy-sell agreements prevent business-damaging disputes
When a business owner dies or leaves a company unexpectedly, disagreements among the remaining owners and outside parties, such as a deceased owner’s heirs, pose a threat to its financial health and continued existence. A buy-sell agreement can help mitigate such risk.
What does it do?
A buy-sell agreement is a legal document that gives parties the right or obligation to buy shares when a “triggering event” occurs. These events include an owner’s death, disability, divorce, termination of employment or withdrawal from the business.
Properly structured, the agreement limits ownership and control of the business to a select group such as co-owners, family members or members of management. This helps prevent the company from falling into the “wrong” hands — for example, those of an owner’s creditors or former spouse.
How is it valued?
Buy-sell agreements essentially help create markets for what might otherwise be unmarketable assets. Unfortunately, the value of shares in a privately owned company isn’t as immediately apparent as it is with publicly traded shares. So a buy-sell agreement needs to specify the value of ownership interests — or provide a methodology for calculating value when a triggering event occurs.
To help ensure such values will hold up to any legal challenges, engage a professional business valuator to make an initial appraisal, as well as periodic re-appraisals of your company. You want the agreement’s pricing terms to be as precise and unambiguous as possible so they aren’t misinterpreted later on.
How is it funded?
One important role of many buy-sell agreements is to provide liquidity so that a departing owner’s business partners can afford to buy back shares. To make such liquidity possible, you’ll need to “fund” your buy-sell agreement. If your company is cash-rich and confident in its ability to remain so, you could use reserves. However, life insurance generally is a more accessible and less risky solution for funding a buy-sell agreement.
In addition to providing liquidity for remaining owners, life insurance proceeds can help a deceased owner’s heirs pay estate taxes. (See the sidebar “Stay on top of estate tax changes.”) The value of a life insurance policy also might provide liquidity for an owner who retires or becomes disabled.
These are only the most common uses of buy-sell agreements. Talk with your financial advisor about how an agreement can help prevent ownership and control disputes, protect against partners’ fraudulent or inappropriate behavior, and even establish a value of your business interests for gift and estate tax purposes.
Sidebar: Stay on top of estate tax changes
A properly funded buy-sell agreement can provide liquidity to your heirs so they aren’t forced to sell interests in your business to meet estate tax and other obligations after your death. To ensure your agreement is adequately funded for such a purpose, keep an eye on tax laws and inflation adjustments.
Currently, the top rate for the gift, estate and generation-skipping transfer (GST) taxes is 40%. However, the 2014 exemption amount for gift, estate and GST taxes is a relatively high $5.34 million. This exemption is annually indexed for inflation, so be sure to regularly review the value of your business interests and adjust your buy-sell agreement’s funding accordingly.