by Beverly and Chris Amon
Closely held businesses, especially multi-owner corporations and partnerships, need to have a buy-sell agreement in place, though individually-owned businesses may also benefit from the use of such an agreement. A buy-sell agreement is essential for a smooth transition of ownership upon the occurrence of certain events, particularly the "Eight Ds" highlighted here:
- Determination of value. The most important item in a buy-sell agreement is the fair and equitable valuation of the business interest. Appraisals may be viable, even required, if family members are involved in the transaction. Proper valuation also serves to fix the value in the deceased's estate for federal estate tax purposes, with a stipulation that the value be fair market value at the time the agreement is entered into. If life insurance is not purchased to fund the full value, then the funding gap should be covered through the purchase of an installment arrangement, where payments with interest are spread out over a predetermined term with the principal due at the end of that term.
- Death of a shareholder. An owner's death may cause a serious financial setback (key person loss). The problem can be compounded in situations where the surviving shareholders must take on a new partner (the deceased's spouse) whose business acumen may be lacking. Harmonious transition of the business can be accomplished with a buy-sell agreement fully funded with life insurance coverage.
- Disability of a shareholder. While most buy-sells account for the contingency of death, many are underfunded and ignore a potentially more serious financial drain–disability. A disabled shareholder may continue to expect to receive a salary and profit-share. Decisions on salary and profit-sharing, and any variation by length of disability, should be outlined in the agreement. The agreement should be fully funded and spell out courses of action contingent on the length of the disability.
- Departure of a shareholder. When a shareholder leaves, whether for regular retirement or early voluntary retirement, the shareholder's business interest should be purchased at a price equal to or less than the death price. A lower purchase price might be set for early termination. As for retirement planning, a life insurance policy can provide a death benefit with its cash values used as a retirement supplement.
- Divorce of a shareholder. A divorce could result in the nonowning spouse owning up to one-half the business interest of a closely-held company. A provision in the buy-sell agreement should force such a spouse to sell back the stock to either the a) corporation, b) original shareholder, or c) other shareholders, with the price no higher than the death price.
- Deadlock. If owners with equal shares disagree on an important matter, the business can become "deadlocked" and normal operations may cease. In this case, the business may have to be liquidated, so such a scenario may have to be contemplated in the agreement to maintain ongoing operations.
- Disagreement among owners. If ownership is unequal and there is an irresolvable disagreement, a minority shareholder could be forced out of active employment. In that case, it may make sense to purchase that shareholder's interest, with such a scenario also considered in the agreement.
- Default. In most closely-held corporations, the individual shareholders must personally guarantee corporate loans from banks and/or contribute payments to the bank or business. A provision should be included to trigger a buy-out for a shareholder's interest if that shareholder defaults.
The Eight Ds serve as a beneficial checklist when drafting or reviewing a buy-sell agreement. It's preferable to optimize decisions with the input of the potentially affected parties before a triggering event, rather than facing the pressure of such decision-making after the triggering event occurs.
Opinions expressed in this article are those of the authors and do not necessarily reflect official policy of the Society of Actuaries or the Entrepreneurial Actuaries Section (EAS). The reader should not strictly rely on the content of this article. It is recommended that the reader correspond with a legal and financial expert before crafting a buy-sell agreement for a closely-held business.
Beverly Amon, FSA, CFA and Chris Amon, FSA, CFP®, ChFC, CRPC® own Amon & Associates/Sagemark in Windsor, Conn. They can be reached at www.AMON360.com or 860.298.1846.