Owners of manufacturing and distribution companies are often so focused on the here and now that planning for future catastrophes may fall through the cracks, especially if the owners are young and healthy. But operating without a valid buy-sell agreement is like driving without car insurance. Failure to either update an old buy-sell agreement for ownership changes or to execute one altogether can cause financial distress and even tear a company apart if tragedy strikes.
Cover all the bases
Private companies enter into buy-sell agreements to address voluntary and involuntary changes in ownership that might occur in the future. Examples of events that could trigger a buy-sell agreement include:
Death of an owner: When an owner dies, a buy-sell dictates how the deceased owner’s interest will be handled. Will heirs inherit the shares and have a say-so in future business decisions? Or will the company (or the remaining shareholders) buy the interest? If so, will the buyout be funded by life insurance?
Owner departures: When an owner retires, leaves to pursue other interests, or becomes disabled, the buy-sell should spell out the departure terms, including the owner’s post-departure role in decision-making, buyout terms, and whether the departing owner’s interest will transfer to a designated heir if he or she dies.
Irreconcilable differences among owners: When owners fundamentally disagree on a company’s direction and want to leave the business, the agreement states how disputes will be resolved and what rights dissidents have.
It’s a good idea to iron out details when owner relations are amicable. Lawsuits are common when owners wait to discuss issues related to ownership changes until after problems have already started to unfold.
Address valuation issues
When a “triggering event” occurs, the parties are usually at odds over the value of the business. Resolving valuation issues when the agreement is drafted can help ensure that all parties are treated equitably when the unexpected strikes or disagreement mounts.
Some owners opt to have the business valued when they’re drafting the buy-sell agreement. Then, they use that static value to buy out a departing owner’s interest whenever the buy-sell is triggered. But fair market value (FMV) can change as market conditions and the business evolve, and a valuation performed many years ago may become stale.
Alternatively, owners may decide to have the business valued annually, so the FMV is readily available and there aren’t any surprises when the buy-sell is triggered. Or they may prescribe a valuation protocol to follow when the agreement is triggered, including how “value” is defined, who will value the business, whether valuation discounts will apply, who will pay appraisal fees, and how the buyout will proceed.
Weigh the options
The two most common types of buyout structures are cross-purchase agreements and redemption agreements. Under the former, if an owner leaves the business (voluntarily or not), the remaining owners have the right to buy the departing owner’s interest either in one lump sum or in installments, depending on how the buy-sell is written. In case of death or disability, cross-purchase agreements also may be funded by insurance.
In a redemption agreement, the company itself, not the individual owners, buys out the departing owner’s interest. The value is effectively transferred to the remaining owners by reducing the number of outstanding shares. Life insurance policies (in which the company is named as the beneficiary) may be used to fund redemption agreements, too.
Avoiding transfer pitfalls
Many manufacturing and distribution companies are family owned. But passing the torch from one generation to the next isn’t always the best decision. Today’s owners should realistically assess whether their children have what it takes to run a successful operation.
It’s tough for owners to treat their loved ones as employees first, but that’s how to objectively evaluate their abilities. Promoting a relative who’s not qualified or up to the task typically backfires. It could cause reduced morale among workers who aren’t related to the owners and eventually lead to the departure of key employees.
Owners can draft ownership transfer agreements that list benchmarks for a potential successor to achieve before acquiring an interest in the company. For example, a potential successor could be given the goal of achieving a certain growth percentage in his or her division or hitting predetermined sales targets over the next 12 months. Whatever the goal, the agreement should be specific.
Also meet with potential successors to find out whether they even want to take over. Parents sometimes find out that their dreams of passing on a legacy don’t align with their children’s plans for the future, forcing them to find an alternate exit strategy — sometimes at the last minute.
Iron out the details
In any buy-sell agreement, the key is to be clear and comprehensive. The more details that are put in place today, the easier it will be for owners to resolve issues when the unexpected strikes, disputes arise, or an owner simply decides to call it quits.
If you have questions about creating a buy-sell agreement, please contact a KraftCPAs representative. We’d be happy to assist you.