Buy-Sell Agreements

What is the problem?

The problem is, what happens to a business or its owners / partners / shareholders when one or more of them leave the relationship, by choice or otherwise? Who gets what? How much is it worth and how will it be paid for? Under what circumstances can a partner be forced out? Who decides if he / she can stay in the relationship? Who makes the final decision in the event of a dispute? How do values get established?

Most people go into a partnership with others because of some high regard for the other partner. The best time to decide what will happen when one needs to depart is while the high regard continues: before the animosities or disagreements set in. Best to establish the parameters of dissolution before there is any real thought of dissolution, while there is still a “golden rule” aspect to the relationship. Once these issues are settled the participants usually have the essence of a buy-sell agreement or of a shareholders’ agreement.

What are the issues?

A partnership, whether a legal partnership or an incorporated one (private corporation) is not unlike a marriage. There are five main areas of concern: death, disability, incompatibility, and retirement.

The survivors of a deceased partner may expect the business to provide the necessities of life as did the deceased but they would not have the capability of earning it in the business as did the deceased.
A disabled partner will not be able to pull his or her weight but will require cash flow to survive, probably more than when not disabled.
Nobody will want to be in business with someone who does not want to be in
business with them: the business will be strained to survive such a turn.
Members of the partnership might have difficulty in getting their money out of the business in order to retire without some proper planning well ahead of time.

Evaluation of the business

Most businesses are worth more to their owners than to anyone else. But in the case of small businesses, professional partnerships, etc, the value of the business is usually related to the partners themselves and their contribution to the business. Evaluating a business interest after the departure of a key member of the firm will show a different number than before the departure.

A buy-sell agreement should establish a formula for evaluating the business for all contingencies. Often a multiple of earnings is the approach, using a period of time such as the three years before the death, disability, or announced departure of the member. Or it could be an average of a number of months’ or years’ earnings. Earnings could include items such as management drawings, dividends to members’ spouses, etc.

A Golden Rule approach often works out well in setting up such parameters since those making the agreement do not know in advance who will be the beneficiary and who the victim of the clauses in the agreement. In other words will you be doing it to the other person, or having it done to you?

Allowance needs to be made in the agreement for the value to fluctuate and this is why a multiple of earnings usually is the most popular method of striking a fair value at which one partner would buy out the other.

Funding the share purchase

How to pay for the shares being purchased needs to be addressed carefully in an agreement. What is the use of an agreement if it is unenforceable due to lack of funding? If the purchase is to be paid for from on-going earnings of the business over several years into the future, the business could be broke by then. The partner who sold would not get his money and, obviously, the purchaser would not be pleased with the value he got for what was paid. As in buying any major asset, usually a significant down payment is made and the rest may be spread out over a number of months or years, with or without interest. Sometimes a residual interest is retained by the selling partner until, say, one-half of the agreed price has been paid.

The death or disability of a shareholder may be easier to deal with since these are insurable risks. Incompatibility of the partners is not. Retirement of a partner is something that can be planned for, and funded, in advance. Either way, however, usually there are payments required over and above any insurance proceeds and there needs to be protection for both the purchaser and the vendor.

The purchaser needs to be sure he or she is not so strapped making payments that the business goes broke as a result. The vendor will need to be sure there are enough funds in the business so that payments can continue.

Disability

The agreement needs to address what constitutes a disability. Does one have to be in the hospital? Is the partner disabled if he cannot make it to the office, cannot read, cannot do most of his job, cannot do all of his job, cannot do any of his job, or what? Relatively few such agreements address this issue at all and even fewer fund it with insurance, which makes the agreement somewhat unenforceable.

When a disability buy-out insurance policy is used to fund this aspect of a shareholder / partnership agreement, the disability definition in the policy itself is the best one to follow. Such policies can be tailor-made, within limits, to the exigencies of the situation. They can be made to pay a lump sum or to make monthly payments, or both, after an initial waiting period of, say, one year. The waiting period can be used as the determination period as to whether the disabled person will or will not be returning to the business. At the time the insurance pay-out commences, these funds can be used as the down payment in acquiring the disabled person’s share of the firm. The agreement needs to address how the balance of the purchase price, if any, is to be paid. The agreement should also require that the proceeds be used for this purpose since, otherwise, the recipient of the insurance might not be required to buy the shares. It is not up to the insurance company to enforce the terms of a partnership agreement. Often it is a good idea to have a trustee own the policy on behalf of all parties and be required to enforce the terms of the agreement when the benefits are paid.