In his seminal book The Seven Habits of Highly Effective People, Stephen Covey advises his readers to “Begin with the End in Mind.” This advice holds true when you are working on a business plan for a new company – you should always include an exit strategy addressing how the business will continue (or dissolve) if one or more of the owners no longer can participate in the operation of the company. One of the best ways to craft an exit strategy for your company is through the use of buy-sell agreements.
A buy-sell agreement is a legally binding agreement between co-owners of a business that sets forth the terms upon which an owner’s equity stake in the business may be purchased. When negotiating a buy-sell agreement, below are some of the key issues to consider:
What events will trigger the purchase right?
At a minimum, most buy-sell agreements will address the situation where one of the owners dies or otherwise becomes incapacitated. However there are numerous other situations where it might be desirable to have the buy-sell agreement grant a purchase right, such as when an owner retires, moves away, quits working for the company or when the management of the company is deadlocked.
Who has the right to purchase the equity?
The right to purchase the equity can be held by the company or by one or more of the co-owners of the business. The identity of the purchaser can impact the tax treatment of the sale (both for the selling owner and the remaining co-owners).
How is the purchase price determined?
The most frequent formulation is that the purchase price will be determined upon the fair market value of the company based upon a valuation conducted by a competent and neutral third party. This approach has the benefit of ensuring that the purchase price is “accurate,” but the drawback is that one of the parties (or both) will have to incur the costs associated with the valuation company. Furthermore, because valuation is as much art as it is science, agreeing to a valuation company may be difficult and one of the parties may dispute the methodology used. To address these concerns, some buy-out agreements will utilize formulae based upon earnings, revenues, asset value or other criteria to either set the actual purchase price or to set parameters on the purchase price.
When will the purchase price be paid?
Typically, the purchaser will have some period of time following the triggering event to exercise the right to purchase. The purchase price may be paid in a lump sum or paid over a series of years. In order to ensure the company has the funds necessary to pay the purchase price, some buy-sell agreements will be funded through the use of key-man life insurance policies.
One of the great advantages of negotiating a buy-sell agreement at the beginning is that the co-owners typically do not know at this time whose interest will be purchased pursuant to the agreement. As a result, everyone is generally focused on making sure the buy-sell agreements are fair and practicable.
If you are interested in learning more about buy-sell agreements, please contact Douglas Park Law