Have a Small Family Business? You Must Have a Succession Plan
When we work with companies that have more than one owner, we should always ask the owners, “Is there a governing document that dictates what happens if something terrible happens to one of you?” According to the Small Business Administration, less than 10% of family businesses have a formal plan, and less that than two-thirds of such businesses do not survive through the second generation. This wasteland of small businesses is due to the lack of planning!
A buy-sell agreement is a legally binding contract primarily designed to control the following business decisions:
- Who can buy a departing owner’s share of the business (is it limited to other owners, family members, or can ownership be sold to an outside party?);
- What events will trigger a buyout (death, deadlock, bankruptcy, divorce, disability, retirement, termination of employment, loss of license, sale, etc.); and
- What price will be paid for departing owner’s interest in the company?
Small businesses fail, because these questions are not addressed. A comprehensive buy-sell agreement is designed to answer these questions before serious issues arise and can prevent infighting and litigation between family members, and co-owners.
The buy-sell agreement sets forth the rights and obligations of each business owner upon the occurrence of specified events.
There are two general requirements in buy-sell agreements: 1) an agreement; and 2) a method to fund the agreement. Transfer agreements are vital to the perpetual operation of a closely-held business. Important goals of buy-sell agreements include the following:
- Insuring the orderly transfer of control;
- Providing a market for the stock, membership interests, or partnership interests;
- Estate planning;
- Fixing the value of the company for estate tax purposes;
- Protecting S corporation elections;
- Resolving owner disputes; and
- Protecting owners from the claims of creditors.
TRIGGERING EVENTS AND KEY TERMS
The most common events that cause the terms of a buy-sell agreement to be triggered (i.e., “triggering events”), are generally death and disability, and involuntary transfers such as divorce or bankruptcy, retirement, termination and deadlock. In addition to triggering events, the agreement should include a method to determine the value of the company at the time of a triggering event (valuation methods are discussed below) as well as the terms of the payment. Common triggering events include:
- Death – The death of a shareholder may trigger a mandatory purchase of shares. Without provisions for a death buyout, the interests of the deceased owner may be transferred to an inadvertent owner through the residuary clause of a will or by intestacy. Cross-purchases or redemptions give the remaining owners the ability to determine and continue their ownership while allowing the decedent’s successors to terminate their holdings at a predetermined price and terms. Life insurance is often purchased on each owner to provide liquidity to the company or the remaining owners so assets do not need to be sold.
- Sale / Retirement – Business owners often depart the business at different times, so provisions need to be made to control the disposition of shares and the payment for those shares. Many agreements provide a right of first refusal to the continuing owners, and allow the departing owner to sell to an outside party only if no owner elects to acquire his shares.
- Involuntary Transfers – An involuntary transfer due to judicial actions, such as a bankruptcy or divorce decree will result in a bankruptcy trustee, creditor or ex-spouse becoming an unwanted shareholder of the business. Provisions that trigger a redemption or cross-purchase will prevent the potential transfer of ownership to an unwelcome individual.
- Disability – In the event that an owner who is also an employee becomes disabled, often defined as the inability to perform the services that have been associated with the position for at least six months, the buy-sell should provide for terms that allow the disabled employee/ owner to terminate his interest, enabling the smooth transition to new ownership.
- Termination of employment – A buy-sell should include provisions that address the consequences of the termination of an owner’s employment, whether termination is with or without cause, voluntary, or involuntary.
- Deadlock – Deadlock provisions are those provisions which determine how disagreements on key issues involving a company are to be resolved. The principle underlying them is that a successful business enterprise should not be destroyed solely because the two partners are unable to agree on a core issue.
- Estrangement – If co-owners of a business can no longer operate the business in a harmonious fashion, it is often necessary for one of the owners to depart the business. However, the owners may not agree as to who should depart. A “shotgun clause” is one of the most common types of estrangement clauses. In such a provision, one owner (the initiator) will elect to exercise the shotgun clause. The initiator is required to state a price to completely sell his or her interest or buy out a non-electing owner’s interest. The non-electing owner, within a proscribed time, then may either accept the offer to sell his or her interest or force the initiator to buy the non-electing owner’s interest at the offered price. The initiator controls the price, while the other owners control the disposition of the ownership interest.
In many cases, litigation and disputes will arise because the parties (the continuing owners and the departing owner) cannot agree on the value of the company. Because there is no existing market for company shares with established prices, one of the primary purposes of a buy-sell agreement should be to provide a method of establishing a value of the interests to be transferred. It is important that the agreement provide a definitive value or, alternatively, provide a definitive method or formula for determining the company’s value.
