As an entrepreneur and business owner there are several benefits that derive from operating your own business: the freedom and ability to set your own future, the ability to do what you enjoy, and the promise of a profitable company built from your own sweat equity.
What most entrepreneurs don’t see is their business operating without them. This is where the practice of having a buy-sell agreement in place will prove an essential tool in your business playbook. Buy-sell agreements can be a way to protect the business and ensure that it continues to operate if one of the shareholders is unable to or chooses not to participate in its operations. This article will summarize some of the reasons why having a buy-sell agreement in place can be so important.
A buy-sell agreement is an agreement among the owners of a business that fixes the owners’ rights with respect to each other and with respect to the business enterprise. A buy-sell agreement can be very important to the owners of a closely held business because it can serve several purposes among them:
(1) providing a ready market for the stock;
(2) restricting the transfer of stock to prevent ownership by undesirable parties; and
(3) in the event that one of the owners passes away or becomes disabled, providing a way to transition their ownership interests.
Thus, as a practical matter, the agreement can provide a framework for the owners to resolve a number of issues that might otherwise lead to conflict later.
Setting The Market
Without a buy-sell agreement, the price and marketplace of your business can be a huge unknown. The value of a closely held business is not like a share of Microsoft or General Motors where the price to buy and sell is public knowledge and occurs in a public marketplace.
A closely held business is an illiquid asset that has a limited market. A buy-sell agreement will set the price and how the price to be paid for the shares will be determined. This will become essential when dealing with a dissenting shareholder who wants to exit the business and when dealing with a deceased shareholder’s heirs in the determining the value of the deceased shareholder’s stock. Additionally, a buy-sell agreement can spell out the payment terms to the exiting shareholder.
Restricting The Transfer of Stock
Another important provision typically found in a buy-sell agreement among shareholders is a provision restricting the ability of the shareholders to transfer stock to others against the wishes of the other shareholders. Not only can this prevent the transfer of stock to an undesirable new shareholder but this can also be important when the corporation is an S corporation.
S corporations have restrictions on the number and type of shareholders. A buy-sell agreement can spell out that the stock cannot be transferred to an ineligible shareholder which would cause the corporation’s S election to be revoked.
Providing For Transition
In the event of an untimely death or disability of a shareholder, a buy-sell agreement can provide a structure for cashing out the ownership interest of a shareholder. A buy-sell agreement can provide a vehicle for the corporation or the shareholders to purchase the stock of a deceased or disabled shareholder. This becomes paramount in a situation where the exiting shareholder’s spouse and children have no familiarity with, or expertise in, running the business yet depend on the income therefrom to pay living expenses and to fund anticipated future expenses such as college tuition.
But it is important that such a provision be funded by either life or disability insurance. Few companies have the cash on hand to buy back a disabled or deceased shareholder’s stock and continue to operate at their normal level. Buy-sell agreements that are funded will ensure that the spouse and children of the deceased or disabled shareholder will receive adequate compensation for the stock and provide peace of mind to them in knowing that this situation has previously been addressed.
As an example of the importance of having a buy-sell agreement in place, let’s imagine the owner of a newly created business—we will call him Joe—who is at a meeting at a customer’s office. The meeting goes well but as Joe is leaving, he collapses to the floor. The customer contacts emergency officials but to no avail.
Joe has tragically passed away and leaves behind a wife, young children and employees. Joe was young, vibrant and seemingly bulletproof. He has no buy-sell agreement in place. Fortunately, his story has a happy ending as some colleagues stepped in and were able to shore up the business in the short term and find a buyer.
But the question remains, is there something in place to protect your business and your heirs, if a fate similar to Joe’s were to happen to you? If you do have an existing buy-sell agreement, you may want to review it and see if it meets your current operating needs. As they say, “Life comes at you fast.” Using a buy-sell agreement in your business can help you to be prepared when it does.
Content contributed by John W. Kapelar, CPA, CVA, Managing Director with Potter & Company, P.A., a locally based certified public accounting firm offering core services of audit, business consulting, tax, and financial analysis. For more information, contact him at 704-283-8189 or visit www.gotopotter.com.