What a Buy-Sell, or Buyout, Agreement Can Do

Contrary to popular belief, a buy-sell agreement is not about buying and selling companies. A buy-sell agreement is a binding contract -- between you and your co-owners -- that controls when an owner can sell his interest, who can buy an owner's interest, when the company or co-owners must buy another owner's interest, and what price will be paid for that interest. In this book, we use the terms "buy-sell agreement" and "buyout agreement" interchangeably.

Guarantee a Buyer for Your Ownership Interest

At a time when many people demand that their work be both profitable and personally meaningful, you may decide that the business is not working out for you as you expected, or you may no longer get along with one of your co-owners, or you may even have to move to another city because your spouse takes a new job. Whatever the reason, you'll no doubt want to turn the value of your share of the business into cash -- to provide you with retirement funds, seed money for another project, or even a down payment to buy a vacation house.

The Problem

If at some point you want to leave the business but your co-owners won't pay a fair price for your interest, without a buy-sell agreement you could be stuck with a share of the company, instead of having cash to spend or invest elsewhere. Why?

Your co-owners may not want to part with the money it would take to buy you out -- at least not at the price you want. And you're not likely to have luck selling to a third party either. It's often impossible to find an interested buyer for part ownership of a company, especially if you're trying to sell a minority interest.

It shouldn't come as a surprise that it can be quite difficult to sell a less-than-100% share of a small business. A minority share gives an owner little or no control over how the business is run. Think of it this way: If your dream has been to own and run your own business, would you be likely to settle for a tiny piece of someone else's? Probably not -- if you are like most people.

The Solution

If the time comes when you want or need to sell your ownership interest, having a buyout agreement that provides for forced buyouts can end up protecting you and your family from financial hardship and hard feelings. A buyout agreement can give you the right to force the company or the co-owners to buy you out under certain circumstances, and at a set price. A buy-sell agreement typically gives owners this right when any of the following occur:

• An owner decides to move on to something else or to retire after a certain period of time.
• An owner becomes disabled and is no longer able to actively participate in the company.
• An owner dies, and the estate representative or inheritors want to sell his interest back to the company or the continuing owners.

For instance, if you have to move out of state for family reasons and want to sell your ownership interest, or you become disabled and can no longer work, your agreement could require your company or co-owners to buy your share from you. In effect, this type of provision "makes a market" for your interest where one might not naturally exist.

Or, if you die unexpectedly, requiring the company to buy back your interest from your estate provides financial stability for your heirs -- assuming they would inherit your chunk of the company after you die.

Example: Dean, Ivan, and Winter, coworkers in a large cosmetics company, quit their jobs to form a natural cosmetics corporation. Unfortunately, although they spend a lot of time developing a business plan and organizing their business, they do not create an agreement or mechanism to fund a buyout, should one of them want to sell out.

Three years after the corporation was formed and just when it is beginning to earn substantial profits, Ivan dies, soon after his fiftieth birthday. His wife and two children each inherit an equal number of his shares. But his wife is strapped for cash, and his kids, just entering college, also need money. Neither his wife nor the kids are interested in continuing the business. Dean and Winter don't feel the company can afford to pay the true value of Ivan's shares to his family, and they know that Ivan's heirs probably can't find an outside buyer. They plead poverty and initially refuse to buy the shares. Ivan's wife and kids are stuck. Dean and Winter finally agree to buy their shares for far less than they were really worth, by making small payments to the family over five years.

This is not an uncommon situation in small businesses. Often, when an owner dies, the last thing family members want to do is pick up the business where the owner left off. But families who are grieving the loss of a loved one may also suffer financially, from living expenses, funeral costs, and death taxes. In that case, it's really necessary for an inheritor who does not want to carry on the business to be able to offer her interest to the company and the remaining owners of the company and be guaranteed that they'll buy it for a fair price.

We look at the ways a buy-sell agreement can provide forced buyout rights in Chapter 3, "Providing the Right to Force Buyouts."

Control Who Can Own an Interest in the Company

When the shoe is on the other foot, and you're the one who wants to stay while another owner leaves, you'll want some guidelines in place to keep the ownership and control of your company stable and the business solvent. This may happen when a co-owner wants to sell out because he is not getting along or he simply feels like doing something else.

The Problem

As discussed above, an outsider who gains an ownership interest could disrupt business as usual and trigger major problems in any small company's management. For example, a new owner with different goals might not see eye to eye with the existing owners on the election of the management team (board of directors, general partners, or limited liability company managers) or the approval of important management decisions. And since unanimous agreement of all owners is required for certain decisions, a new owner could hold up important company actions.

Even worse, an unwanted outsider in a corporation, especially one who buys or inherits a large block of shares, can gain control by electing herself to the board of directors. Once a person becomes a board member, she becomes an equal participant on the board. Let's look at how an unwelcome outsider can disrupt a company's management.

Example: Cousins Xavier and Yolanda incorporate a small business, with Xavier receiving 55% of the corporation's shares and Yolanda 45%. Each cousin serves as a director of the corporation. A few years later, Xavier and Yolanda have a falling out over whether to significantly expand the business. To escape from the resulting tension, Xavier sells his 55% interest to Richard, a wealthy investor Yolanda doesn't even know, and sets off to spend his days sailing the sunlit Caribbean.

Richard elects himself to the board of directors to fill Xavier's seat. He immediately proposes laying off several loyal employees in order to maximize short-term profits, with an eye towards making a quick and lucrative sale of the company. This horrifies Yolanda, who is interested in the long-term health and growth of the business. Richard and Yolanda quickly reach an impasse in corporate decision making, and Yolanda files a minority-shareholder lawsuit, trying to unseat Richard. This escalates their personal and professional conflicts, with the result that the company's day-to-day operations practically come to a standstill.

Likewise, in an unincorporated business, an outsider can sometimes take control automatically by becoming a majority owner in the partnership or limited liability company (LLC).

The Solution

When an owner is contemplating selling or giving away his interest, a good buyout agreement steps in to give the continuing owners some control over the transaction, often regulating who can buy the departing owner's interest and at what price, or, sometimes, whether the owner can sell his interest at all. The agreement gives the continuing owners the tools to prevent outsiders from buying in.

Usually a buyout agreement also gives the company and its owners the opportunity to buy out an owner who stops working for the company. By so doing, it eliminates the possibility that active owners will be forced to share profits with an inactive owner. A buyout agreement can also give owners the right to purchase an owner's interest after he dies rather than allow his inheritors to become owners.

In fact, a typical buyout agreement gives the company and the owners the right to buy out an owner (that is, force an unwilling owner to sell) in all of these situations:

• The owner becomes disabled and is no longer able to actively participate in the company.
• The owner's ex-spouse stands to receive an ownership interest in the company as part of a divorce settlement.
• The owner's interest is in danger of being confiscated by creditors (because of a personal bankruptcy or foreclosure of a debt).
• The owner decides to retire from active participation in the company.
• The owner dies.

We discuss these options in Chapter 2, "Limiting the Transfer of Ownership Interests," and Chapter 3, "Providing the Right to Force Buyouts."

Set a Price for a Buyout

An important part of adopting a well-thought-out buyout agreement is setting a price at which ownership interests will be transferred. Without establishing a price for the company in advance -- or at least a formula for setting the price -- lengthy disputes and lawsuits can arise over the value of an ownership interest. Not only are these disagreements almost sure to result in personal ill will, but they may even disrupt the ongoing business to the point that the company loses its edge and is in danger of failing.

However, it can be difficult to value a small or family-owned business. Sure, you can add up the value of property, equipment, and accounts receivable, but what about the value of your customer lists and your business's reputation -- sometimes known as the "going concern" value? Should these assets get factored into the equation? And, of course, whatever number you come up with, a departing business partner could have a different idea of the company's worth: The departing owner could be thinking of a price based on the increasing profits over the last three years, while you may be fearful that the owner's departure is going to hurt sales or make the business's future uncertain.

We discuss setting a price for buyouts in Chapter 6.

Arrange a Payment Method for a Buyout

Likewise, a company that doesn't plan how it will pay a departing owner (or his family members) can be in for trouble. Having to come up with a large lump-sum payment out of the blue can cause a company to drown in financial hot waters. These issues can be extremely problematic if a payment schedule is not determined until the time when the ownership interest has to be bought back. For instance, if an owner wants the company to buy back his interest and pay for it on the spot, the company may need to borrow the cash (of course, some can't) or liquidate assets to make the payment.

Fortunately, a good buyout agreement can set forth the mechanics of a buyout -- including specific payment terms. A buy-sell agreement can provide that a departing owner (or his family members) can be paid in installments, perhaps from company revenues, over a period of years, which will be more affordable for the continuing owners than a lump-sum payment.

We discuss payment methods for buyouts in Chapter 7.

Fund a Buyout

To cover the possibility of an owner's death or disability, one common funding method is to require the purchase of life or disability insurance for each of the business owners -- and then use the policy proceeds to buy an owner out if an owner dies or becomes disabled. Without a funding mechanism, in some cases your company's only other option might be to liquidate or file for bankruptcy -- something you surely want to avoid.

Example: Imagine the same circumstances as the above example, except this time Dean, Ivan, and Winter create a buy-sell agreement at the outset. The agreement protects the owners' inheritors by requiring the corporation to buy back an inheritor's interest at a price based on a professional appraisal. It also provides that the buyout will be funded with company-purchased life insurance. The life insurance proceeds will keep the remaining owners from having to take out loans or sell assets to execute the buyout. Thanks to the buy-sell agreement, Ivan's wife and kids receive a reasonable sum for their shares, at no financial strain to the company.

In addition to, or in combination with, funding a buyout with insurance, if you plan ahead, departing owners can be partially compensated with deferred compensation or retirement plans. We discuss funding buyouts further in Chapter 5.

Tying It All Together

It is your job (along with your co-owners) to decide which of these provisions you want to include in your buyout agreement. After reading the first part of this book, which explains the various buyout options mentioned above and how they can be used, you and your co-owners will choose the buyout provisions you think are suitable for your company and your situation. You'll select provisions for your agreement depending on several factors, including how long you expect to own your business, whether you want to keep your company very small and private, and who you expect to succeed you when you die.

When Should You Create a Buyout Agreement?

Procrastination is a vice most of us share, and that includes many small business owners, no matter how shrewd they may be. Unfortunately, in the area of business planning, it can lead to financial undoing. Many owners of successful businesses put off creating a buyout agreement -- because they don't have time, or they think nothing's going to change -- until it's too late. In short, no matter what stage you're at in the business game, the time to create a buyout agreement is now.

When you're forming a new business, by the time you have the notion that you need to talk about "What happens if ...," fatigue has probably set in. Often little energy is left over for hashing out the provisions of a buyout agreement. But creating your buy-sell agreement need not be an arduous ordeal. For instance, there's no need to spend a lot of time on complex valuation formulas (for example, the capitalization-of-earnings method) when you're just starting out. In fact, you couldn't use one of the more complicated formulas early on even if you wanted to -- they require that you have a few years of earnings history. Later, as the worth of your company grows, and as you develop an earnings record, you can refine your valuation formula to reflect changes in the company's assets and earnings.

The key to a buyout agreement is that all owners agree to a reasonable plan early on, before anyone knows who will be most affected by it. Think of it this way: At the outset, each owner's concerns are roughly the same, because no owner knows who will be the first to leave. Or put another way, it's only when no one wants to sell out that everyone has the same interest in creating an evenhanded buyout agreement that's fair to all owners.

Not coincidentally, the best time to discuss these issues is during the formation stage of your company, when you're already discussing other potentially sensitive issues -- such as the amount each owner will invest, the salaries or draws each owner-employee will take home and the policies that will guide your company.

New owners sometimes worry that focusing on problems surrounding an owner's leaving casts a shadow over their new business. Just the opposite is true: Facing the fact that problems can arise and that negative things do happen can be healthy for your business relationship. Airing concerns, and perhaps a little dirty laundry, often helps you to head potential problems off or, if that's impossible, to be sure they will be handled smoothly, without putting your business's survival at risk. Knowing that possible changes are covered and planned for can act as a reality check and a stabilizing force and can increase your trust in what the future will be like.

No one may want to bring up the awkward issue of what happens if the owners stop getting along or if someone wants out of the business before the others do. But making decisions together with your co-owners from the start can make a world of difference in the future of your company because it requires you to discuss major questions that affect your future. Begin by being frank with your co-owners now.

Does Everyone Need a Buy-Sell Agreement?

Almost every business should have a buyout agreement. In only a few situations, a buyout agreement may not be necessary:

• One owner. If you are a sole proprietor -- you own 100% of a company -- you probably do not need a buy-sell agreement, unless you plan on selling the business to an employee who is willing and able to take over (see "Employee Buyouts" in Chapter 5).
• Married owners. If you and your long-time, highly compatible spouse (with whom divorce is highly unlikely) own 100% of a company, there normally is little reason to bother creating a buy-sell agreement. It's unlikely that either of you will want to get out of the company unless you both do, and if one of you dies while you still own the business, the other person will probably inherit the ownership interest.
• Parent/child owners. If you co-own your small business with your son or daughter (alone) and you plan to leave your share of the business to them at your death, you may want to forgo a buy-sell agreement and just put your wishes in a will or trust (unless your estate may owe estate taxes -- see "Estate Tax Issues" in Chapter 9). But even here there is always the possibility that your child will die, divorce, or want to leave the business before you do, so an agreement still makes sense.

In short, there may be some situations where it is unlikely you'll need the protection of a buyout agreement, but you usually take some sort of risk by not having one.

How to Create Your Agreement

Throughout the first part of this book, we present and explain various buyout provisions you can use to handle ownership transition issues, from deciding which potential problems may affect you and your company to choosing how you'd prefer to handle these dilemmas.

We provide a lot of the legal and tax information you need to make informed choices about the future of your company, including the following major issues that will help you decide on the terms of your buyout agreement:

• how to put limits on whom an owner can transfer his interest to (Chapter 2)
• how to provide for forced buyouts in certain circumstances (Chapter 3)
• how the procedure works for buyouts in the future (Chapter 4)
• how to fund future buyouts (Chapter 5)
• how to set the price that will be paid for ownership interests (Chapter 6)
• how to set the terms of payment (such as an installment plan) (Chapter 7), and
• how buy-sell agreements can affect ordinary income and capital gains taxes and estate taxes (Chapter 9).

Throughout the book, after introducing you to these concepts, we help you choose the provisions that are right for your company. This book will be your companion in making these decisions with your co-owners, providing practical and supportive information along the way.

To keep track of the options that interest you, and any related thoughts you may have, we provide you with a worksheet that follows the order of the chapters and the issues we discuss. Before you start reading Chapter 2, tear out the worksheet from Appendix B, and keep it by your side while you're reading. The text will prompt you to check various options and jot down any relevant notes on your worksheet.

Finally, when you've gone through the book, you'll simply transfer your choices from your worksheet to the blank buyout agreement we provide by filling in the blanks. (The agreement comes as a tear-out form in Appendix C and as a word processing document on the CD-ROM.) Then you'll print it out and have all owners sign it. Later on, during an ownership transition, the provisions you choose will remind you and your co-owners how you agreed to handle a potential buyout situation.

One practical suggestion: Take it easy. As you read through the book for the first time, you may feel a bit discombobulated by the numerous possibilities that can be covered in a buy-sell agreement. Expect to feel a bit overwhelmed. Not every company needs to cover every contingency. And there's no need to grasp every detail the first time through. Start by reading the entire book to get a rough understanding of what's involved and making a few observations on your worksheet about what situations or provisions might be particularly applicable to you.

Then spend time considering what you want to happen to your business when you are no longer in charge. Creating a buy-sell agreement has important, long-term consequences for you and your family, and your finances. Allow plenty of time for discussions with your co-owners -- talk, argue, and speculate. Perhaps give each owner a worksheet of their own to fill out. When you're ready, go back, focus on the areas of most concern and begin to pin down exactly what you want in your agreement.

After you select the appropriate buyout options and sign your buyout agreement, it will then probably sit quietly in a dusty file folder until you or a co-owner wants to part with his ownership interest or until an event happens that causes the company or co-owners to want to buy out an owner. When one of these circumstances occurs, the buyout agreement will kick in to protect your investment.

When to Seek a Lawyer's Advice

While we provide a lot of information in this book to help you create your buy-sell agreement, we cannot provide the depth of advice, especially in the tax and estate planning realms, that a buy-sell or financial planner or a tax expert can provide. Since we don't know you and your particular business, we can't customize an agreement for you that exactly suits your company's and each owner's individual needs, though we do make every attempt to provide different alternatives and tips on customizing your own agreement.

So, in general, we recommend you bring your draft buyout agreement to a small business tax or legal advisor before putting your finalized agreement into action. Consultations of this sort are invaluable to make sure that you have considered all the relevant tax angles and the contingencies that apply to your particular business and to make sure you base your agreement on the very latest tax information and strategies. In addition, a lawyer can make sure that your new buyout provisions don't conflict with existing provisions of your business's organizational documents -- your articles or bylaws or partnership agreement or LLC operating agreement. (For more information, see "Finalizing Your Buyout Agreement" in Chapter 8.)

Some situations may even merit a conversation with a lawyer or tax planner before you create your buy-sell agreement:

• Family business owners. If you own a family business and your plan is to have children or other relatives succeed you, you may need some extra help with succession planning -- issues of inheritance and estate taxes can be complicated for family businesses. And although some family members may not want to consider the chance that there may be disagreements in the future, the truth is that serious disputes can and often do arise in family businesses -- just as they do in families themselves. We discuss issues that apply to passing the family business from one generation to the next in "Family Succession Agreements," in Chapter 3, but families with high-value businesses or those with complex succession plans may need to bring in advisors (tax experts or estate planners) to help them mesh their buy-sell provisions with their estate planning needs.
• Minority/majority owners. If you will own a small minority or a large majority of a business, or you are a silent investor in a company, you may want to seek legal advice that's tailored to your circumstance. You may have some extra concerns that we don't fully address in this book. This book is geared toward companies with two or more owners who are unrelated, who own roughly equal shares of the business, and who actively participate in the day-to-day management or operations of the business.
• Owners with different situations. If the needs or circumstances of the owners are substantially different, and the owners' initial capital contributions will be quite high, each owner may wish to check out the tax and estate planning repercussions with his or her individual tax advisor or financial planner.
• Older owners. If you are in your fifties or sixties and are forming a new company with others and contributing a lot of cash or property, you may want to consult an estate planner before you adopt your agreement. In particular, choosing the right valuation formula early on can have a minimizing effect on estate taxes when you or a co-owner dies. We discuss estate taxes as they relate to buy-sell agreements in Chapter 9.

If you decide to have an expert prepare your buyout agreement rather than do it yourself, you'll benefit greatly by understanding the critical issues, your options, and having thought about your expectations for the future of the company. You may want to create a draft of a buyout agreement -- or at least fill out the worksheet in the appendix -- and bring it with you to your first meeting with a lawyer, along with any questions you have. It will help your planner immensely in knowing where you're at and what you want out of an agreement, and may save you time and money.

In Chapter 10, we discuss how to find an attorney, or legal "coach" -- a helpful professional who will review your buy-sell agreement for you.

Introduction

The first days and months of a new business are busy times. The last thing you have time for is worrying about what will happen when you or another owner wants to get out of the business -- or becomes disabled, gets divorced, or dies. Unfortunately, it's a huge mistake to ignore the fact that, sooner or later, your business will lose owners and perhaps gain new ones. After all, do you know what you'll be doing five or ten years from now? You can't be sure that the business will fulfill all of your financial and emotional needs and that you'll want to stay involved forever. You can be sure about one thing, however: You will leave your business at some point, whether it is to start another company, become an employee somewhere else, move, retire, or, god forbid, become disabled or die when you're not expecting it.

If you are the owner who leaves first, you don't want to leave your investment and hard work behind. You need a way to convert your business interest into money that you can take with you. To make sure this happens, you and your co-owners may want to agree that the company or the co-owners will buy out an owner who wants or needs to leave -- at least under certain circumstances.

Or, if it turns out that youare the owner who wants to stay with the company for the long haul, losing an owner or gaining a new one may throw you off course. When ownership interests change hands, conflicts often arise that can upset the functioning of a small, closely managed company. If you doubt this even for a minute, quickly skim the following questions:

• What if one of your co-owners demands you buy him out for an unreasonable price, at a time when the company is under financial strain?
• What if your longtime friend and business partner gets Alzheimer's disease? Can you buy out his share? Can the person's caretaker force you to buy the share?
• What if one of your co-owners becomes alcohol or drug dependent or loses her professional license? Can she be expelled?
• What if a co-owner gets divorced and her ex-husband ends up with part ownership because of the divorce settlement?
• What if the majority owner of your company wants to sell his share to a stranger?
• What if an older co-owner wants to give half of his interest to his notoriously irresponsible son, who has never worked for the company, and elect him to the board?

The answer to all these dilemmas is the same. If you haven't made a sound agreement to anticipate and deal with these issues before they happen, you're taking a risk that friction will arise between owners who will remain at the company and a new owner or a departing owner. Much of the time, this tension occurs because the continuing owners do not want to be forced to work with and share control of the company with an unqualified, inactive, or unlikable new owner. (After all, most small business owners own their own businesses because they want to run things their way, or at least share management with co-owners with whom they can comfortably and easily deal.)

When such owner-to-owner tension arises, it can lead to serious personal and business discord, which might even be fought out in court or result in the demise of your company. Put bluntly, if you do not have a buyout agreement, here is what may happen:

• If a stranger is allowed to buy the interest of a departing co-owner, or a family member of a deceased or divorced owner receives an interest, the new owner may be inexperienced or untrustworthy; this could end up hurting the company's bottom line.
• If a co-owner is forced to file for personal bankruptcy or defaults on a personal loan secured by his ownership interest, you may be stuck co-owning the company with a bankruptcy trustee or creditor. This can create business delays and prevent you from getting bank loans.
• If a co-owner -- or her inheritors -- want to be bought out, you and your co-owners may argue endlessly over what price should be paid for the interest that is changing hands, resulting in an angry deadlock that spills over into business operations.
• If you leave the company or die, you or your survivors may be stuck with a small business interest that no outsider wants to buy and for which no insider (co-owner) will give you a decent price.

To avoid these conflicts, you and your co-owners should arrange matters so you'll be able to collectively control who will own and manage the company in the future. In other words, if someone wants to buy into the company, you and the other owners can have a say. If an owner wants to give his share to his kids, you and the other owners may want say no. If an owner wants to retire but hold on to his interest, you and the other owners may want to rearrange things. That's why it's best to set some ground rules ahead of time. Enter the buyout agreement (sometimes also called a buy-sell agreement or a business continuity agreement).

Much like a prenuptial agreement, a buyout agreement gives owners a way to deal with ownership disruptions in a way that won't wreck their business, by providing preestablished rules for transferring interests. After all, you probably started your own business to work with people you enjoy and to control your own destiny. A buyout agreement will make sure it stays that way.

Of course, planning in advance to contend with likely disputes is not the same thing as saying you can prevent change -- for good or bad, your company's ownership situation is almost sure to be different five years hence. But you can plan for transitions with a buyout agreement -- to make the transition process as positive and as smooth as possible -- and put your mind at ease.