Buy/Sell Agreements: Business Exit Strategy

Once a decision has been made to go into business the next big step is usually deciding what form the business should take. Is a sole proprietorship the right choice or should a partnership, limited liability company (LLC), or corporation be chosen. Deciding on the right business form is clearly a critical decision. Once a form is chosen formative documents must be drafted.

LLC’s require some form of articles filed with a state agency and an operating agreement. Partnerships require a carefully drafted partnership agreement. Corporations will require articles and bylaws. New businesses often try to cut costs and draft these documents themselves without professional help. This approach can often lead to major problems in the future. However, at least an effort is often made to produce the necessary formative documents. Once the business entity is formed most business owners feel they are ready to launch the new enterprise and they throw all their energy into growing it. Are they really ready to go? Have they really taken all the essential formative actions? The answer is decidedly, no! When a business begins there should be entry, growth, and exit strategies. The emphasis invariably is on entry and growth and almost never on exit. This is a BIG business mistake.

Exit Strategy

If the owners do not have a definite and clear idea about when they will end their involvement with the business they risk never having/living the life they have always wanted and could have had. All too often business owners continue working in the business until they dies of a heart attack or other illness without ever having developed a plan for exiting the business. Once the owners agree that an exit strategy is essential, appropriate documents can be drafted. Without doubt the most important document in implementing an exit strategy at this point is a Buy/Sell Agreement.

What is a Buy/Sell Agreement?

In order to successfully exit a business a number of issues must be resolved. These issues are best addressed at the beginning of a business and not after it has been operating for a number of years. At this point if the business has been successful it may be more difficult to discuss business valuation and control. Those who remain may have far different interests and views about the business than those who are leaving. In order to minimize conflict and considerable harm to the business a Buy/Sell should be drafted early in the life of the business.

Issues to Address in a Buy/Sell Agreement

A typical well-drafted Buy/Sell Agreement will address the following issues:

  • Selecting a method for valuing acceptable to taxing authorities;
  • Determining who can acquire ownership interests and when;
  • Determining an order of precedence for acquisition of ownership interests;
  • Determining how to fund the purchase of ownership interests.

A well drafted agreement will also accomplish the following:

  • Provide a relatively simple way to transfer ownership interests between family members and other owners;
  • Provide a ready market for ownership interests which are otherwise not marketable;
  • Provide for protection of business know-how and trade secrets upon transfer of ownership interests;
  • Provide for non-competition by prior owners, upon transfer of ownership interests.

As can be seen from the above, a well-drafted Buy/Sell Agreement addresses critical issues relating to the business and it’s owners.

Valuation of Ownership Interests

A Buy/Sell Agreement can be used to help establish estate and gift tax values for ownership interests. The fact that values can be set in advance in a Buy/Sell Agreement can remove uncertainty and allow for advance planning. The values established in a Buy/Sell may also be less than might be determined if a Buy/Sell Agreement were not used resulting However, in order to have the Buy/Sell Agreement values set estate tax values the agreement must meet four (4) tests:

  • The estate must be obligated to sell it’s ownership interest at the owner’s death;
  • During life the owner was not free to sell their interest to anyone outside the agreement without first offering it to the other parties to the agreement;
  • The agreement had a business purpose (Keeping the business in the family meets this test);
  • The terms of the agreement are similar to what would be acceptable in parties dealing at arm’s length.

Who can acquire an ownership interest and when

A Buy/Sell Agreement can take three forms:

  1. Redemption
  2. Cross Purchase
  3. Hybrid Format

Redemption Agreement

A redemption agreement is a contract in which the owners agree to sell their ownership interests to the business upon the occurrence of a specified event (i.e., death, retirement, disability). A redemption agreement can result in adverse tax consequences if not structured properly. The sale of an ownership interest to the business may result in the entire purchase price being taxed as a dividend rather than a capital gain without any recovery of the owner’s basis. Although dividends are currently taxed at a low rate this may change in the near future.

Cross Purchase Agreement

In this form of Buy/Sell Agreement the other business owners agree to purchase the interest of the selling owner. The purchasing owners increase their tax basis in their existing shares by the amount of the purchase price they pay. This form of Buy/Sell is often preferred for it’s simplicity.

Hybrid Agreement

A hybrid agreement provides more flexibility than a redemption or cross purchase agreement. The business is given the first right to buy the owners interest but if the business will not or cannot buy the entire interest then the other owners can purchase the remaining interest. One form of hybrid agreement is called the “wait and see” agreement. In this form no decision is made as to whether the business or the other shareholders will buy the interest until a specified event occurs. Thus, depending upon the circumstances when the owner sells, either the business or the owners may be the purchaser. Usually the business is given the first opportunity to buy the interest then the other owners can buy the remainder. If the other owners do not buy the remaining interest the business must buy the remainder.

Funding the Buy/Sell Agreement

Finding the cash to buy the interest of a deceased, disabled or retiring owner can be a major problem for a family business and for the other owners. As a result, the business and other owners often purchase life and/or disability insurance to fund the buy/sell agreement in the event of death or disability. In the case of a redemption agreement, the business will buy a policy on the life of each owner. In the case of a cross-purchase agreement each owner will buy a policy on the life of each other owner. The use of life insurance is not always an ideal vehicle. However, although the proceeds are not taxed under the regular income tax the proceeds may be subject to the alternative minimum tax. Also the cash value of the policy may not be sufficient to fund a buy back due to disability and retirement. In the case of disability or retirement the ownership interest could be purchased on an installment basis. However, if the business accumulates cash to fund a future buyout it is not a “permitted purpose” and could result in the imposition of the accumulated earnings tax.

Protecting Against Competition

A Buy/Sell agreement can also serve to protect the business from competition and loss of trade secrets and know how when the owner sells his/her interest in the business. It can also protect a majority owners control or protect the interests of minority owners. Voting agreements, irrevocable proxies and voting trusts can be part of a Buy/Sell Agreement. A voting agreement is a contract between owners in which they agree to vote their interest to elect certain individuals as managing owners. An irrevocable proxy is an agreement in which one owner gives another owner the right to vote their ownership interest, or the right to vote for all other owners. A voting trust is an arrangement under which owners give up their voting right to a trustee who votes their ownership interests according to the terms of the trust agreement. A Buy/Sell Agreement is a good place to restrict a selling owner form then competing with the business by entering into the same line of business once they have sold their interest. It is also a good place to provide for non-solicitation and non-servicing provisions. These provisions prevent a selling owner from soliciting existing business employees and existing business customers. Finally, a Buy/Sell agreement can be used to prevent a prior owner from using the company’s confidential information, trade secrets, and know how to compete with the company after they leave.

As you can see from the above, a Buy/Sell Agreement is a very useful, if not essential, business planning document. As there are several potentially complicated issues that can arise, it is highly recommended that you utilize the services of a qualified attorney to draft a Buy/Sell Agreement.

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