In a recent post I described why closely-held business owners need a “buy-sell” agreement to provide for the orderly disposition of a business owner’s interest in the business upon his or her death. Absent a buy-sell agreement, a deceased business owner’s interest in the business might well end up passing to a surviving spouse or children who have no involvement in the business. Bringing in “outsiders” to participate in an operating business is almost always a recipe for disaster.
While most of the focus in drafting a buy-sell agreement tends to revolve around the “death” issue, it is equally important that the agreement take into account other critical life events such as disability, retirement and sales of business interests to third parties.
According to the National Underwriter, a 42-year old is four times as likely to become seriously disabled then they will die during their working years. Most business owners I know work long hours, and if a closely held business were to lose the services of one of its key players for any significant period of time, the business’s operations would be severely hampered. The owners of a closely-held company should ensure that disability coverage is in place covering each of the owners. Such insurance might provide, at minimum, that income “lost” because of the absence of an owner due to disability is available to business to cover overhead. The firm’s buy-sell agreement can provide that the non-disabled owners would have the option to purchase the interest of a permanently disabled owner, and disability insurance can be obtained to help fund the purchase of those interests. Even if disability insurance has not been obtained, the cash value of any life insurance on the life of the disabled owner may be used to fund the buy-out. None of these options are possible, however, unless the buy-sell agreement has been drafted to include specific disability buy-out provisions.
It is also critical that in drafting the agreement the business owners address the common situation where an owner retires or otherwise leaves the business. I have seen many agreements incorporate a loosely based definition of “retirement” that essentially allows a business owner to walk away at any time, and requires the remaining owner or owners to immediately purchase the departed owner’s interest. Not only might the remaining owners have to come out of pocket with significant amounts of cash – or be burdened with large promissory note payments if the agreement provides for installment payments – but they must do so at a time when the business has lost the services of a key person. Properly counseled, very few business owners would opt for such a result.
One solution might be to permit a “retirement” only if an owner reaches certain milestones (for example, attaining the age of 62 with a minimum of 20-years service). The buy-sell agreement might specify that an owner who departs the business prior to the stated retirement milestones might have no ability to sell his interests to the other owners or to any third parties. Or, the agreement could specify that the remaining owners have the option to buy-out the departing owner, but are not obligated to do so if the economics do not make sense. Language can be included that provides that an owner who leaves prior to the “permitted” retirement date would not share in the appreciation of the business if it is sold to a third party at some future date, and might in fact be required to take less than the fair market value of their interest (valued as of the date of their departure) if the business’s value subsequently declines. This mechanism is designed to protect the remaining owners if the value of the business suffers as a result of the lost services and good will attributable to the departed owner.
Another important consideration in buy-sell planning is determining when, if at all, that an owner can sell his interest to someone other than another current owner. Owners in most closely-held business wish to restrict any sales to third parties except if the remaining owners unanimously agree to such a sale. While such restrictions impair the liquidity of an owner’s interest, they also ensure that all owners will be “partners” only with those persons with whom they are comfortable working.
The buy-sell agreement should also include address the concepts known as “tag along” and “drag along” rights. “Tag along” rights protect minority owners in circumstances were the majority owners contract to sell the majority interests to any third party. A tag along provision might provide that the majority owners can only sell their interests to third parties if minority owners are afforded the same sale rights and at the same sale price per share. Under a “drag along” provision, if the requisite percentage of ownership interests required under the buy-sell agreement vote to sell the entire company or its stock to a third party, then owners of the minority interests would be obligated to participate in the sale.
Buy-sell planning presents many unique challenges and opportunities. Successful planning requires that business owners commit the requisite time and resources necessary to engage in thorough discussions with their professional advisers. A well-designed buy-sell agreement can ensure that the business will survive beyond the current ownership group. But if a business has a poorly designed agreement – or like too many businesses, no agreement at all – then that business’s long-term survival will be questionable at best.