Imagine this scenario: After you and your business partners worked your entire lives to build a successful enterprise, one partner dies unexpectedly. The spouse inherits the partner’s interest in the business but has no interest in becoming an active participant. Yet the spouse wants—or needs—the cash flow the business had been generating for her. Your business cannot handle the cash drain or the brain drain and is forced to liquidate to settle the matters.
What happened? And why? Couldn’t you, your partners, or the company have bought out her interest? Maybe you tried but couldn’t agree on value. Or maybe you didn’t have the means to pay her. In any case, the result is the same: years of hard work gone and nothing to pass along to the next generation.
A situation like this can be avoided with a properly executed buy-sell agreement. A buy-sell is simply an agreement between or among business owners that spells out what is to occur upon a triggering event of any of the owners: death, disability, divorce, retirement, or desire to sell.
Buy-sell agreements typically provide for the purchase of the exiting shareholder’s interest at a predetermined price (or based on a set formula) for the circumstances. Buy-sell agreements enable the process to happen in a somewhat automatic fashion, removing the emotion, trauma, or drama from the situation and providing what both sides really want: liquidity for the exiting shareholder or his/her estate, and an ongoing business for the remaining owners. Buy-sell agreements also help to avoid the often devastating in-fighting that can happen among owners and spouses or heirs in the absence of such agreements.
Depending on the terms of the agreement, the buyout of an owner’s interest may be made either by one of the remaining owners (through a cross-purchase) or by the company (through a redemption). Many use a hybrid approach in which the owners have the right of first refusal followed by the company. The remaining owners can also approve the sale or transfer of an interest to an outside party if they know or trust that the person will be a good business partner.
As for the funding of a buy-sell, it may come from the current cash flows of the business or from the ownership group (in a lump-sum or installment arrangement), depending on the circumstances. In many cases, the buyout of an owner at death is covered through proceeds from a life insurance policy established for this purpose.
With proper planning and a little effort to institute a buy-sell agreement, you can be sure that you and your family will get the most from the business that you worked so hard to create.
Michael A. Coakley can be reached at Email or 215.441.4600.