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Buy-Sell Agreement – Drop Dead Plan

March 5, 2013

Any business with more than one owner – a corporation, partnership or limited liability company – must have a shareholders’, partnership, or members’ agreement.  Such an agreement is a WILL for a business.

 

Imagine the complications, problems, issues and controversies that arise when a part-owner dies and there is no such agreement.  Other issues arise when an owner becomes disabled, imprisoned, files personal bankruptcy or goes through marriage dissolution.  All of these circumstances should be addressed.

buy-sell

Another issue that can be covered is when an owner wants to reture or leave the business.  These are two different situations.  Someone may want to go to work elsewhere or start a competing business while a retiring partner usually won’t.

 

That being said, when understanding that there are many different variations of such agreement, three issues should be determined:

 

  • the trigger points – what causes the buyout to become effective
  • the valuation – what price will be paid
  • payment terms – over how long a period will the payments be made

 

The co-owners need to keep in mind that they could be on either side of the future transaction, and without an agreement, they may leave a mess for their partners and family.

 

I believe it is best to have a comprehensive plan and agreement.  Getting everything ironed out early on in the relationship is important and gets this “chore” put aside.  However, many business owners have difficulty making decisions regarding the “split up” of their business which is what occurs when one of the owners makes the decision to leave.  So, the agreement never gets completed.

 

DEFAULT PLAN: I have a default plan suggestion for people that can’t or won’t make the decisions needed for a complete agreement rather than continuing with no agreement.  The plan involves getting something in place if there is an untimely death or disability with the other issues considered at a later date.  Ideally, there should be a complete agreement, but covering these two potentially solves a lot of problems, and limiting it makes it easier to get something done.

 

A suggested default valuation for the buy-sell agreement is to use the current “fair market value” or other agreed-upon basis for valuing the company with future annual adjustments for increases or decreases in book value.  Payments should be made over a five to ten year period with interest at the then current applicable federal interest rate.  I suggest that in a worse-case scenario, a new valuation be obtained every five years.  Ideally there should be a new valuation every two years.  One further adjustment would be if the business is sold for a greater price within one year after the buy-sell transaction takes place.  In that situation, the buy-sell value would be adjusted to a pro rata portion of the actual sale price and the payment terms will be consistent with the terms of that sale. There will be no downward adjustment.

 

Buy-sell agreement valuations concern the IRS where low values are routinely scrutinized to make sure there isn’t a gift element in the transfer.  However, while the IRS looks at the values and compares them to “fair market value” that is not necessarily the proper standard since the valuations are not for cash payment and there are other elements removing it from FMV such as a necessity to sell and buy because of the trigger event causing the sale.  This is a discussion for another time, but the main issue here is to protect the company and the deceased owner’s family, and that makes executing such an agreement a must.

 

Death and disability are also two situations that can be insured against, in most cases.  Life and disability buy-out insurance can be looked into while you are have the agreements prepared.

 

If you don’t have an agreement, get it done using this blog as a guide!

3 Comments leave one →
  1. March 20, 2013 6:23 am

    In establishing an agreement, two parties should have fair market value. By doing buy-sell agreement, it protect the business from loss of revenue.

Trackbacks

  1. Valuation for Drop Dead Buy-Sell Agreement | The Partners' Network
  2. What Happens When an Owner Dies Without a Buy-Sell Agreement | The Partners' Network

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