Succession Planning for Business Owners, Part 2:

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1 Succession Planning for Business Owners, Part 2: The Buy-Sell Agreement Dave Pullin

2 Succession Planning for Business Owners, Part 2: The Buy-Sell Agreement Dave Pulin Our previous article on succession planning at noted that as a business owner, your ultimate long-term success can only be established at the very end of the day, when you sell your business, retire, or leave the business for reasons of death, disability, or economic circumstances beyond your control. To maximize the likelihood of achieving the kind of success that you and your family want, need, and deserve, there are many important considerations, including ownership structure, long-term value drivers, and appropriate tax, insurance, financial, legal, and contingency planning. But for those who are not the sole owners of their business for those whose business is an LLC with other members, or a corporation with other shareholders, or even an old-fashioned partnership with other partners probably no document is more critical to long-term success than a buy-sell agreement. Also known as a buyout agreement, a business will, or even a corporate prenuptial agreement (because like a marriage, a business is often easy to get into but very hard to get out of), a buy-sell agreement spells out, among other things: Who can (and in some cases, who must), and who can not, buy a departing owner s share of the business; What events will trigger a buyout, including, for example, death, disability, retirement, or an outsider s offer to purchase a co-owner s interest; What price will be paid for a shareholder s, member s, or partner s share of the business; and How any buyout will be funded, which usually and most effectively takes place through life or disability insurance either cross-held by the owners on each other or held by the business entity itself. 1

3 As Important As They Are Potentially Problematic With a buy-sell agreement in place especially one adequately funded through insurance many potential unknowns are eliminated, thereby making long-term financial planning for everyone involved much more feasible. For example, a buy-sell agreement can provide a liquid market that might not otherwise exist for the shares of or membership interests in a business. And with a buysell agreement in place, you can rest assured that you will not have to be in business with the inexperienced spouse or children of your nowdeceased partner. Alternatively, without a buy-sell agreement, matters can rapidly become adversarial and chaotic, with the parties being forced to rely on generic state law statutes and courtroom proceedings to bring matters to an ultimate conclusion. Given that a death or disability of a co-owner already is an emotionally difficult time, and given that the business may have lost key operating expertise and knowledge, the last thing anyone wants in these circumstances is a protracted, expensive, legal battle. Also, the existence of a buysell agreement can be particularly valuable for those who hold a minority interest in a business, and may otherwise be at the mercy of those who hold the majority interest. What makes buy-sell agreements inherently problematic, however, is that to do one right to thoroughly assess the desires of the various owners and then come up with a binding agreement that does the best possible job in meeting everyone s concerns both now and in the future often takes a great deal of work. That is, while buy-sell agreements are somewhat simple in concept If one of us leaves, for this or that reason, here s what we ll do with the ownership interests and how we ll pay for and handle the transfer they are actually among the more intricate and laborintensive agreements that business lawyers typically craft. So while the optimum time to really think through and craft a thorough and fair agreement is when a business is being created, that s just when the resources and attention needed to create such an agreement are often hard to come by. 7 Rules of Thumb Since buy-sell agreements are simple in concept but often very tricky to flesh out, this section sets out a series of 7 Rules of Thumb (R.O.T.) that will help summarize some of the 2

4 most important factors and help orient you in the right direction. Some of these Rules of Thumb are more appropriate to those who are just creating a business with multiple owners, others to those who already have such a business and do not yet have a buysell agreement, and others to those who already have a buy-sell in place and need to keep it updated and relevant. The point here is to raise your awareness as to the general considerations that you should keep in mind, and in the conclusion to this article we ll consider the advantages of working with an experienced wealth manager in terms of creating or updating your buy-sell agreement. R.O.T. # 1: If you are a co-owner of a substantial business, then having a buy-sell agreement is a necessity, not a luxury; without one, effective realistic long-term personal financial planning is nearly impossible, and eventually you or your heirs may find themselves in a world of pain and expensive, rancorous, litigation. R.O.T. # 2: While the best time to put a buy-sell agreement in place is when your business is being formed, it s never too late, and if you don t have one it should become a top priority. (While an LLC s operating agreement or a corporation s bylaws may sufficiently cover the same ground that a buysell agreement covers, this is the rare exception.) R.O.T. # 3: Ideally guided by a trusted financial advisor, work closely with an attorney, accountant, and insurance agent to make your buy-sell agreement as simple, clear, and fair as possible, both so that if and when a triggering event (death, disability, retirement, etc.) occurs, everyone involved will know just what needs to happen and will comply, and also because you can t be sure whether you (or your heirs) will be on the buying or selling side of things. R.O.T. # 4: Buy-sell agreements that are funded by insurance are highly preferable, because the money needed to buy a co-owner s interest once a triggering event occurs is rarely readily available in liquid form (in the business itself or in the accounts of the other owner or co-owners); to convince yourself of the advantages of funding the buysell through insurance, ask an insurance agent to sketch out some scenarios comparing the costs of paying for insurance premiums versus coming up with the cash to buy your co-owner s interest. Note that while you can decide to self-insure, this should not be done out of ignorance, and in most cases a review of the different scenarios involved in a funded versus a non-funded buy-sell agreement will rapidly and readily convince you of the tremendous advantages of the former. R.O.T. # 5: It s best to work closely with an insurance agent, an accountant, and an attorney in terms of funding a buy-sell agreement because there are a number of different options in terms of what type of insurance to buy and who will hold the 3

5 insurance policy, including each owner holding a policy or policies on the other owners (which can become very complex if there are multiple owners), the business itself holding the policy, a mixture of the business and the owners holding the policy, and the creation of another entity (such as a trust) to hold the policy, all of which have different tax implications. R.O.T. # 6: While it s rare to have a buy-sell agreement state that insurance or some other mechanism must be used to fund the agreement, it s a very good idea for the agreement to state that all insurance proceeds that are available on an insured person s life must be used immediately to purchase the available interest after a triggering event, either as payment in full or as a down payment along with a work-out over time. R.O.T. # 7: It s best to work closely with a wealth manager, an accountant, and an attorney in setting the price for the value of the business and buying out an owner s share because there are many different ways of doing this, including setting a fixed price, using one of several different business valuation formulas to set a price, and relying on one or more appraisers; if a specific price is set in the buy-sell agreement, it should be reviewed on an annual or two-year cycle, and then if insurance has been purchased to fund the buy-sell agreement, the amount of insurance should be adjusted to reflect any change in price. How Working With An Experienced Wealth Manager Can Help In Wealth Management for Business Owners: An Introduction the very first article in this series, we presented an overview of the many advantages you, as the owner or co-owner of a business, receive from working with a trusted and experienced wealth manager. By assisting you with both business and personal/family financial planning, by steering you in the right direction with respect to legal, accounting, and insurance needs and potential problems, and by helping you address issues that are specific to businesses, you are freed up to do more of what you do best, that is, run a successful business. One such issue specific to businesses is selecting and maintaining the right retirement plan, as we discussed in detail in another previous article, and another is business succession generally and buysell agreements in particular. While this article covered some of the basics of buy-sell agreements, it really only scratched the surface. If you are working with a wealth manager, he or she will be able to help you identify the individual circumstances relating to you and your co-owners that should be considered when crafting your buy-sell agreement. Further, a good wealth 4

6 manager will be able to introduce you to both an attorney and to an insurance agent who is experienced in buy-sell agreements. These experienced professionals, especially if they are guided by a wealth manager who knows you well, will help make sure that the buy-sell agreement fully addresses your particular situation and circumstances. In many cases, a good wealth manager working in tandem with an experienced attorney and insurance agent will be able to help you identify standard solves that is, common buysell agreement clauses that might directly address some or most of your needs, thereby saving you time and money in the long-run. Ultimately, a good wealth manager will help you not just with arriving at the right buy-sell agreement, but with committing to do whatever it takes to come up with one that you (and your co-owners) can sign off on in the first place. Just keep in mind that without a buy-sell agreement, long-term personal financial planning for you and your family will typically be difficult and unreliable, if not impossible. So while a buy-sell agreement may seem like a daunting undertaking, it is an absolutely critical element for any successful business with co-owners. Fortunately, the process of arriving at the right one can be greatly streamlined by working with a wealth manager who can both identify your individual needs and can help you identify and efficiently work with the right attorney and insurance agent. The author wishes to thank Jim Pittman, of Insurance Consulting Services, Inc., see and Laura E. Vaught, Esq. and Joseph D. McDonald, Esq., of Smith, McDonald & Vaught, LLP, see for their time and their valuable insights into buy-sell agreements. Dave Pullin offers Securities and Advisory Services through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. He is located at 8440 Southwest Canyon Lane, Portland, OR and can be reached at (503)

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