Why should you have a buy-sell agreement?
Buy-sell agreements are among the most important agreements entered into by business co-owners. Notwithstanding the importance, many businesses do not have buy-sell agreements in place, and for many that do, the agreements are ambiguous and outdated.
An effective buy-sell agreement will eliminate or reduce the disputes arising from the death or retirement of a shareholder or partner, and the absence of an effective agreement may result in a protracted and costly dispute.
Is your existing agreement still effective?
To determine if an existing buy-sell agreement still works for a business, the value of the business should be calculated pursuant to the agreement, as if a triggering event had occurred. If there are not disputes over interpretation of the agreement, all parties believe the value result is fair, and the funding mechanism is in place to make the required payments, then the agreement is still acceptable.
Many companies that perform this exercise find the existing agreement to be unsatisfactory and in need of change. It is much better to perform this exercise and identify problems with the agreement prior to occurrence of a triggering event. In the evaluation of the results of this exercise, the parties will usually be open minded and fair, because they do not know if they will be a buyer or a seller when the actual triggering event occurs.
Types of buy-sell agreements
Buy-sell agreements generally fall into three basic categories: fixed-price agreements, formula agreements, and agreements requiring the performance of a valuation.
In fixed-price agreements, the price is specified in the agreement and is generally funded by an insurance policy, which was purchased at the time the agreement was executed. These agreements usually contain a provision requiring the fixed price to be periodically updated, but this provision is frequently disregarded. Problems can arise when a triggering event occurs and the fixed price value has not been updated, the triggering event occurs after the expiration of the original term insurance policy, or the insurance benefit is no longer sufficient to fund the required payment.
In a formula agreement, the business value is generally determined by a relatively simple formula such as a multiple or percentage of net or gross income. The problem with formula agreements is that although the formula undoubtedly made perfect sense when the agreement was drafted, it may no longer be relevant or yield a result that bears any relationship to current value. Furthermore, if net income is a component of the formula, each expense paid by the business can become the subject of a dispute.
Agreements that require the performance of a valuation by a qualified expert are most likely to yield a fair result and less likely to be the subject of a dispute, as opposed to fixed-price or formula agreements. This business valuation will require payment of professional fees, but these fees will be far less than those that would be paid in the event of a dispute.
Crucial agreement provisions
To avoid or reduce disputes upon occurrence of a triggering event, a buy-sell agreement should include the following provisions:
Standard of Value – This is an important element of a buy-sell agreement. In New Jersey, the most frequently used standards of value are fair value and fair market value. An agreement that uses the generic term “value” and does not state the standard of value to be used will be the subject of dispute.
Triggering Events – Common triggering events in a buy-sell agreement include shareholder death, disability, and retirement. Other triggering events that should be considered are divorce, loss of business or professional license, or one’s continued failure to perform duties. The agreement should also distinguish between normal retirement at or within a range of ages stated by the agreement, and early retirement, which occurs prior to this age or range.
Valuation Date – Upon the occurrence of a triggering event, the valuation date is the effective date of the valuation. In performing the valuation, the valuation analyst can only use information that was known or knowable as of the valuation date. This is important because an event occurring subsequent to the valuation date cannot be considered in the valuation.
Discounts and Premiums – Discounts for lack of control and lack of marketability frequently give rise to disagreement between business valuation practitioners, as well as between practitioners and the Internal Revenue Service. To avoid controversy over application and amount of discounts, consideration may be given to specifying a range or maximum discount in the buy-sell agreement.
Tax Effecting – Most closely held businesses operate as S corporations, partnerships, or limited liability companies taxed as partnerships. With limited exception, none of these companies pay federal or New Jersey income taxes. They are commonly referred to as pass-through entities, because the business income or loss passes through to the owners for inclusion and taxation on their individual income tax returns. Because pass-through entities do not pay income taxes, controversy exists whether income tax expense should be recognized in the valuation of these entities. In drafting a buy-sell agreement, consideration should be given to expressly addressing tax effecting in the agreement.
Although it is impossible to anticipate every contingency and the source of every possible disagreement, an effective buy-sell agreement that is understood by all will go a long way in reducing disputes. Business circumstances change, and the buy-sell agreement may require periodic updating to reflect such changing circumstances. It may be uncomfortable for the parties to discuss sensitive buy-sell agreement issues, but it is far worse to ignore them. Issued not addressed do not go away, they become bigger and more often than not must be decided by a judge. Review and update your buy-sell agreement today to avoid future problems.
We’ve got your back
If you have questions about buy-sell agreements or require an independent business valuation, contact KRS CPA partner Gerald Shanker at 201.655.7411 or [email protected]. You can also learn more from these buy-sell agreement and business valuation blog posts.
This article was originally published in the New Jersey Staffing Alliance July 2017 newsletter.