Payment of the Purchase Price in a Buy-Sell Agreement
For owners of a closely held business, there is perhaps nothing more important than the buy-sell agreement among the owners. A properly structured buy-sell agreement will protect the value of the owner’s interest in the business and prevent protracted disputes when an owner desires to exit the business. The buy-sell agreement is designed to establish a predetermined and agreed-upon business value (or method of arriving at the value) at the occurrence of certain trigger events such as the death, disability, divorce, deadlock, voluntary or involuntary termination of an owner, retirement of an owner or the attempted sale to a third-party.
One of the concerns that must be addressed in a buy-sell agreement is how will the buyout price be paid – this is known as funding. Failure to consider how this will happen can be devastating to both the company and the selling owner (or their family). A few common ways to fund a buy-sell include:
Keeping enough after-tax cash available to pay the purchase price. The problem is knowing in advance if you have enough time to build up the cash fund. We never know when the triggering event is going to happen. It is also difficult to tie-up that much cash at any time.
Borrowing from a bank is pretty straight forward, but there is no real certainty as to whether a loan can be obtained at the time it is needed and what the cost of the money will be.
Installment payments can be a good alternative, but careful thought should be given to the term and interest rate. A longer term and lower interest rate is good for the business, but may be a hardship for the departing owner (or her family).
Insurance can present an excellent option to meet the needs of both the seller and the buyer. The downside, of course, is the immediate premium payout, but the ready source of funds is a big plus. Insurance is not available for all triggering events, but at a minimum it should be in place to fund in the event of a death or disability.
When using insurance, different tax consequences, including whether a death benefit is tax free, can result from different types of structures. So it becomes vital to consult with a qualified team of advisors.
Another issue to be mindful of when structuring the buy-sell agreement is the potential drop in income after departure from the business. For example, if the business has consistently generated $300,000 in annual income, but the buyout price under the buy-sell is $1,000,000. It is unlikely that this amount can be re-invested in a manner that would mimic the annual income the business generated without depleting the principal. Therefore, in addition to any insurance put in place to fund the buy-sell, additional provision should be made, by additional insurance or otherwise, to minimize the impact of the lost income stream.
The buy-sell agreement is a vital part of the planning for any closely held business. The options are many and the ramifications of the choices are significant. If you do not have a buy-sell agreement in place, commit to getting it done and done properly. If you have a buy-sell agreement currently, regular review is important to make sure it is up to date and will work the way you expect. We welcome the opportunity to help you and your business with proper buy-sell planning.