An ownership interest in a closely held business often constitutes a significant part of a business owner’s overall wealth. For owners concerned about preserving the value of this “business capital” for themselves, and/or as a legacy for their families, a well-drafted buy-sell agreement, also known as a buy sell agreement, buy/sell agreement, or simply BSA, by and among all of the owners can be critically important.
A buy-sell agreement is a legally binding contract that stipulates how a partner’s share of a business may be reassigned if that partner dies or otherwise leaves the business. From a business’ inception up until implementation of a final exit strategy by the continuing owners, a BSA is an important tool to help:
- Preserve the business’ long-term viability by preventing control from passing to unwelcome and potentially disruptive parties
- Ensure that each departing owner (or his or her estate) receives a fair price for his or her interest
- Establish a funding source for the purchase of each departing owner’s interest
Primary benefits of a buy sell agreement
Buy-sell agreements have many benefits, one of the most critical of which is to help current owners maintain control and to preserve the marketability of ownership interests.
Maintaining control by current owners
Over the long term, one of the greatest threats to preserving the viability of a closely held entity is the risk of ownership interests passing to outsiders who will disrupt the smooth operation of the business. For example, the children of a deceased owner may acquire an ownership interest through inheritance, but elect not to take an active role in the business. This could lead to clashes between the children and the existing active owners on issues where their respective interests are not aligned—such as whether to distribute or reinvest profits. Under another possible scenario, the former spouse of an owner might acquire an ownership interest through a divorce proceeding, creating an uncomfortable and potentially unworkable operating environment for the existing owners.
In some cases, unrestricted transfers of ownership interests create legal and tax problems for the business. Certain types of entities, such as S Corporations and some professional services businesses, are required to limit their owners to enumerated permissible parties. In these situations, the transfer of an ownership interest to a prohibited party can result in adverse legal and/or tax consequences.
A BSA can mitigate the risk of these adverse outcomes by placing restrictions on transfers of ownership interests. To the extent possible, the restrictions should be structured in a thoughtful manner and accommodate an owner’s desire to transfer ownership interests under his or her estate plan— as long as such transfers are not expected to disrupt the operation of the business. In these cases the BSA can identify and exclude transfers that are part of an owner’s estate plan from the scope of the restrictions.
The restrictions on transfers typically take the form of rights of first refusal given to the business, or the current owners, to purchase the interest of a withdrawing or deceased owner, at a price established under the agreement. Rights of first refusal may be allocated among current owners either equally or on a pro-rata basis, or tailored to specific situations.
Where possible, an owner’s purchase rights should dovetail with his or her individual estate planning goals. For example, if the owner’s estate planning goals include transferring ownership interests to younger family members who are active in the business, it may be advantageous to reduce or eliminate his or her purchase rights in favor of expanded rights for the younger family members. In other instances, where a family’s collective ownership interest is spread across different family members, it may be appropriate to allocate purchase rights in a way that maintains that family’s total ownership interest as family members die or withdraw.
While maintaining control of the business is the most direct benefit of granting rights of first refusal to the current owners, these rights also carry indirect planning benefits for the owners. They make it possible for an owner to anticipate the cost of buying out co-owners’ interests and to develop a plan for funding the purchase in advance. Additionally, they allow an owner to anticipate the value of his or her ownership interest for estate tax purposes, which facilitates effective estate planning. In some cases, the restrictions enable an owner to claim a valuation discount for the ownership interest based on lack of marketability, and thereby reduce gift and/or estate taxes upon transfers of the interests to family members. For owners who anticipate having a taxable estate, valuation discounts based on lack of marketability represent a compelling opportunity for tax savings on transfers to family members.
Preserving marketability of ownership interests
Another benefit of a BSA is that it can create a market for the ownership interest of a deceased or withdrawing owner where none may otherwise exist. This is accomplished by imposing a mandatory purchase obligation on the business, or remaining owners, to buy the interest at a price established under the agreement. In financial terms, this is analogous to granting a “put” option to the withdrawing owner, entitling him to sell his interest at a specified price.
For an owner who anticipates selling the interest at the earlier of his or her death or retirement, the benefits of such a mandatory purchase obligation are considerable. It permits the owner to negotiate the price that will be paid upon retirement, or to the estate following death, well in advance and without unfair pressure. Absent such a provision, the estate of the deceased owner could be forced to either negotiate a sale from a position of weakness, or postpone any sale and risk a liquidity crisis when estate taxes become due and/or the surviving family members require funds for their support.
Beware of pitfalls
Of course, with any type of agreement, it’s also important to understand any potential problems in advance. In some cases, the purchase price set by the buy sell agreement could become unrealistic over time (and at the death of the business owner). The economy and/or business could decline, or conversely, could thrive. If a fixed price is set and not updated over time, this could pose an issue. We cover more on ways to set a fair price later in the article.
Identifying and understanding the potential benefits and pitfalls of a BSA is an important first step in evaluating and/or designing an agreement. The next step is selecting the optimal type of agreement and the most advantageous method to fund the purchases.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. Note that tax, estate planning, and financial strategies require consideration for suitability of the individual, business, or investor, and there is no assurance that any strategy will be successful.
Please see additional important disclosures at the end of the article.