If you co-own a business with other family members, it’s generally a good idea to have a well-drafted buy-sell agreement to protect everyone’s interests. Here are some basics about this important document, including the valuation methods used.
There are two basic varieties of buy-sell agreements. The first type is a contract between the parties to have remaining co-owners buy out the interest of a withdrawing co-owner. This arrangement is called a cross-purchase agreement.
Alternatively, the agreement can be between the business entity and all the co-owners to have the entity buy back a withdrawing co-owner’s interest. This is called a redemption agreement or liquidation agreement.
In either case, the buy-sell agreement has two main purposes:
1. It restricts each shareholder, partner or member of the corporation, partnership or LLC from unilaterally transferring an ownership interest to anyone outside the existing group.
2. It ensures there will be a willing buyer for each co-owner’s interest when he or she retires, dies, becomes disabled or another triggering event occurs.
The triggering events are specified in your buy-sell document. Events that should always be included are death, disability and attainment of a stated retirement age. Other triggering events could be, for example, bankruptcy, the loss of one’s license to practice a profession, the divorce of a co-owner or the desire to cash out by withdrawing from the business.
Under the agreement, when a specified triggering event occurs, that person’s ownership interest must be sold to — or at least offered for sale to — the remaining co-owners or the entity. Next, the buy-sell agreement should stipulate a method for valuing the business ownership interests, along with terms regarding how amounts will be paid out to withdrawing co-owners or their heirs.
Common valuation methods include a fixed per-share price, using an appraised fair market value figure or following a formula that sets the selling price as a multiple of earnings or cash flow. You want to make sure any price-setting method is respected by the IRS for estate tax valuation purposes.
Most buy-sell agreements grant the remaining co-owners or the business entity a right of first refusal to purchase the withdrawing co-owner’s interest. If that right is not exercised, withdrawing co-owners (or heirs) are typically free to sell the ownership interests to an outside party without any need for permission from the remaining co-owners.
The end result is a guaranteed market for each withdrawing co-owner’s interest coupled with the ability of the remaining co-owners to keep control over who can join the business. As you can see, this is a beneficial financial arrangement for all parties — whether you’re the first original co-owner to withdraw or the last owner standing.
A Buy-Sell Agreement Can:
- Transform your closely held business ownership interest into a liquid asset.
- Save taxes.
- Prevent unwanted changes in ownership.