ComplianceOctober 26, 2020

Drafting an effective buy-sell agreement

Unless you are the only owner of your business, it is essential that you have a buy-sell agreement in place from the outset of operations. A buy-sell agreement prevents a co-owner from selling out to a stranger and provides an orderly and equitable method of determining the value of each owner's interest in the business.

A "buy-sell agreement" is an important part of properly establishing your business entity in order to limit liability in your business structure. The buy-sell agreement prevents an owner from selling his interests to an outsider without the consent of the other owners.

The agreement usually takes one of three forms:

  • Cross-purchase agreement. In this form, a withdrawing owner agrees to sell his interest to the remaining owners. This is the simplest form of the buy-sell agreement. It is suitable especially for small businesses with only a few owners. As the number of owners increases, this form can become unwieldy. In a larger business, an entity-purchase agreement may be more suitable.
  • Entity-purchase agreement. In this form of the buy-sell agreement, the withdrawing owner agrees to sell his interest to the entity, which then retires the ownership interest.
  • Hybrid agreement. This form is a combination of the first two. Typically, the withdrawing owner must first offer his ownership interest to the entity. If the entity declines or is unable to make the purchase, then the shares must be offered to the other owners.

State statutes governing the statutory close corporation mandate that the owners enter into a buy-sell agreement. Moreover, sound business planning dictates that a buy-sell agreement also be used in a limited liability company (LLC) or conventional corporation.

Ownership certificates must be endorsed with notice of the restriction on transfer created by the buy-sell agreement. In many cases, state statutes require that precise language be used in the ownership certificates. Thus, it is important to examine the particular state's statute and incorporate the exact required language into all ownership certificates.

A proper buy-sell agreement not only describes how an interest will be sold but for how much as well. The agreement spells out how interests will be valued when they are sold, so as to avoid these kinds of disagreements.

The Business Tools section contains a Sample Operating Agreement, including a buy-sell agreement, for a Delaware LLC. An operating agreement should be professionally drafted and tailored to the needs of the particular owners and the business's operations. The sample operating agreement is for illustration purposes only!

Agreement should specify valuation method

The buy-sell agreement should clearly specify the method for valuing the business interests. After all, in the world of commerce, everything has a price. The problem is, most people have a hard time agreeing on that price. What is valuable to one person may have little value to another. In addition, a business is comprised of any number of variables, each possessing its own values. As with any major purchase, a deal usually has to be negotiated to reach the final price.

To simplify the buy-sell process and ensure fairness for all owners, the buy-sell agreement should specify how the owners' interests are to be valued. Essentially, there are three choices:

  • fair market value;
  • book value; or
  • formula approach.

Warning: Caution must be used in the selection of any formula because of its finality. If the parties have agreed to the formula, it is extremely unlikely that a challenge of its result will be successful.

Fair market value commonly used

When valuing a business interest for a buy-sell agreement, purchase at fair market value requires that the value of the entity's goodwill is included and that the entity's recorded assets be restated to fair market value. Both of these adjustments usually require an appraisal.

Purchase at fair market value is more equitable to the withdrawing owner than purchase at book value. On the other hand, appraisals can be very expensive and, in certain cases, time-consuming.

For this reason, when purchase at fair market value is desired, it is wise to provide in the buy-sell agreement that the parties may agree on "fair market value" informally, and that an appraisal is to be used only in the absence of an informal agreement among the parties as to the fair market value.

Mediation and arbitration clauses in the operating agreement should also apply to any disputes that arise as to the valuation of an interest. This, in itself, may significantly reduce the cost (and time) that will be involved in assessing fair market value.

Business can be valued using book value

Book value represents the allocated amount of the particular interest, as recorded in the entity's accounting records. Thus, the amount is already determined. Accordingly, book value has the advantage that a costly appraisal is unnecessary.

The book value of a business is the amount recorded in the entity's accounting records for the owners' equity in the business. The book value of the business is also equal to the recorded "net assets" of the entity (i.e., the recorded amount for the assets, minus the recorded amount for the liabilities).

Book value should never be confused with fair market value. When an interest is being purchased at book value, the seller is not receiving the fair market value of his interest. Typically, but not always, book value will be lower than fair market value. Thus, purchase at book value is simple but can be inherently unfair to the withdrawing owner.

Book value is likely to be significantly lower than fair market value, especially in a thriving business, for two reasons. Under conventional accounting practices, one very valuable asset is not even recorded in the entity's accounting records--the business's internally generated goodwill. In many small businesses, this will be the entity's most valuable asset, one that, in fact, would represent a significant portion of the purchase price if the business were sold to an outsider. Because goodwill is not recorded, book value automatically excludes goodwill.

In addition, conventional accounting practice is still largely based on the historical cost principle. This principle dictates that, generally, with the exception of certain investments, assets remain in the entity's books at historical cost. In particular, subject to this narrow exception, while assets are written off or depreciated as they expire or, in some cases, when they suffer a decline in value, the recorded amount for assets is never increased for increases in the assets' fair value.

In short, the amounts for assets in the entity's accounting records (i.e., the book value) do not reflect fair market value, but instead, reflect the original cost or a lower amount. In fact, with buildings, the discrepancy between book value and fair market value can be extreme. As buildings age, they are written off, through a process termed "depreciation." Yet, in reality, buildings usually appreciate in value. Thus, over time, the two amounts actually move in opposite directions, making the discrepancy larger.

Formulas can be used to value business

When valuing a business interest as part of a buy-sell agreement, using the book value or the fair market value may not always be the best options. Because of the inherent unfairness of a purchase at book value, and the additional cost, time and complexity involved in a purchase at fair market value, some business owners rely on a formula approach designed to approximate fair market value without a formal appraisal.

One commonly used formula is a purchase at book value, plus an arbitrary percentage (e.g. 5 percent). The arbitrary percentage is supposed to approximate the withdrawing owner's share of the entity's goodwill and of the appreciation in the entity's recorded assets.

Similarly, capitalization of earnings at a fixed percentage is sometimes used to approximate the fair market value of the withdrawing owner's interest. In this method, the entity's average annual net earnings for a period (e.g., the prior three years) are divided by the stated percentage to yield the presumed fair market value for all of the entity's assets, including its goodwill. By subtracting the entity's liabilities from this amount, the fair market value of the entity is derived

For example, if the annual earnings have averaged $90,000, and the capitalization rate is 10 percent, the presumed value of the assets is $900,000. If the liabilities total $600,000, the value of the entity is presumed to be $300,000.

Customizing and funding the buy-sell agreement

A buy-sell agreement can be a flexible as the owners wish it to be. Different methods of valuation can be applied over the life cycle of the business.

For instance, the agreement can initially provide for book value to be used. This makes sense because, during the first year, a new business is unlikely to generate significant goodwill or appreciation of its assets and relationships among the owners could be especially unstable. 

Thus, the agreement can specify, during the one-year period after the buy-sell agreement is signed, fair market value is presumed to be equal to book value. This eliminates the expense of an appraisal, which in any event would probably yield a result that approximated book value.

The buy-sell agreement also can apply different methods to fix the purchase price based upon the circumstances triggering the sale. For example, the agreement might fix a lower amount (e.g., book value) as the price if the owner files a personal bankruptcy action, but a higher value (e.g., book value plus 5 percent, or appraised fair market value) in other circumstances. 

This strategy is open to challenge, so advanced strategies, such as this one, should only be employed with the advice of an attorney.

When circumstances require the owners of a business to execute a previously arranged buy-sell agreement, sufficient cash may not be available to the entity, or to its owners, to make it feasible for the purchase of a withdrawing owner's interest. Usually, if the owners and/or the entity, as the case may be, are unwilling or unable to make the purchase, the buy-sell agreement provides that the withdrawing owner is free to sell his interest to an outsider.

Clearly, this defeats the very purpose of the buy-sell agreement. For this reason, life insurance, on the withdrawing owner's life, is frequently used to finance the purchase of the interest.

When a cross-purchase agreement is used, owners take out life insurance policies on each others' lives. With the use of an entity-purchase agreement, the entity takes out policies on the lives of its owners, with the entity named as the beneficiary of the policies. The cross-purchase agreement is more commonly used in practice.

Obviously, life insurance can only be used to fund a purchase made on account of an owner's death. Funding the purchase of a withdrawing owner's interest, in other cases, can be controlled in several other ways.

The operating agreement may provide that an owner may not withdraw, except upon unanimous consent or subject to other enumerated conditions.

For example, the operating agreement might allow withdrawal by an owner who suffers a permanent disability. "Permanent disability" could be defined as a disability that prevents the owner from working in the business for six consecutive months. Disability insurance might be used, in the same way, life insurance is used, to facilitate the purchase of the interest.

In addition, the buy-sell agreement may provide that, in certain cases (e.g., a voluntary withdrawal) the interest is to be valued at a lower amount (e.g., book value). Moreover, the buy-sell agreement may provide that the interest is to be purchased in installments, over a fixed period (e.g., five or 10 years). Any of these options can make it more practical to purchase the interest.

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