Article: Controlling Company Ownership Via Buy-Sell Agreements

June 2001

Controlling company ownership via buy-sell agreements

A well-conceived buy-sell agreement can help your company and family survive the destructive power of life's transitions

At best, transitions in family businesses are disruptive; at worst, they can be utterly destructive.

Whether the transition is due to death, retirement, termination, divorce or the desire to sell out, the company’s immediate — and perhaps long-term — future may be placed at risk, because its principals’ attention and energies are diverted or because of unexpected demands for funds.

As with many difficult family business circumstances, the possibility of disruptive transitions can be anticipated and should be planned for. The damage potential can be sharply reduced if all parties agree in advance about how various situations will be handled, and that is where the buy-sell agreement can serve as a valuable, company-saving tool.

Buy-sell agreements formalize such understandings with a contractual agreement not to sell or give any shares to anyone outside of an identified group without prior approval of the other family shareholders. Most agreements of this type permit share transfers only to a spouse, child, grandchild, or trust established for them, or to the company itself. Parties who did not sign the agreement but ultimately receive shares are also bound by its terms.

Triggers. Some buy-sell agreements contain mandatory provisions. They obligate shareholders (or their estates) to sell their shares to identified buyers upon the occurrence of a specified triggering event. The agreement also requires the identified buyers to purchase the shares designated to them.

Triggering events may include death, disability, retirement, reaching a certain age, or even a divorce. For example, an agreement could require that, upon death or retirement of a shareholder, either the other owners or the corporation must purchase the departing shareholder’s stock in the business.

Other buy-sell agreements are not mandatory, i.e., they do not require a shareholder or his estate to sell his shares in response to a triggering event. Instead, those shares can be retained by the shareholder or his estate, or they can be sold, willed or gifted within the permitted class of recipients as set forth in the agreement.

Pricing stock. Buy-sell agreements generally provide a method for establishing a price of the shares sold. It is vital that the pricing method be able to survive IRS scrutiny, or shareholders face a potentially devastating double-whammy: On one hand, for tax purposes the IRS can throw out unreasonably low prices set forth in buy-sell agreements; on the other, the IRS can reaffirm the price for purposes of sale. The result: a forced sale, a high tax bill (based on the IRS’s upward adjustment), and not enough money to pay it (since the estate was forced to sell at the artificially low price).

Generally, a buy-sell agreement either puts forth a formula price felt to be indicative of a company’s appropriate value, or directs that one or more outside appraisals be obtained when a triggering event occurs. Common formulas for purchase prices include book value; book value adjusted to the fair market value of certain assets and liabilities; a multiple of earnings; a multiple of weighted earnings over a period of time; or a combination of book value and a multiple of weighted earnings.

Payment mechanism. Having a mechanism to determine price may not be valuable if the terms and means of payment are not specified. Where retirement is a triggering event, or life insurance is unlikely to cover the full purchase price payable upon a shareholder’s death, the agreement should allow the purchaser to pay in installments over time at a fair interest rate.

With a death-triggered purchase, the initial payment should be equal to any life insurance used to fund the agreement. The agreement should tell what to do if more than one shareholder experiences a triggering event. For example, if two or more shareholders die within the same pay-out period, the agreement should indicate how available funds should be split among those entitled to pay-outs.

Buyer identification. Finally, a buy-sell agreement should identify buyers of shares. This is accomplished through either of two methods.

A redemptive buy-sell obligates the business itself to redeem shares. In this case, the business would obtain any life insurance used to fund purchase obligations.
A cross-purchase buy-sell obligates remaining stockholders. Each shareholder would, if possible obtain life insurance on the remaining shareholders and bear a proportionate obligation to buy the shares of any retired or deceased shareholder. Generally, cross-purchases cease to be practical if there are more than three or four shareholders within the group, or if any are uninsurable.

Business importance. Buy-sell agreements are as important to businesses with more than one shareholder as wills are to individuals.

They provide solutions to potential conflicts before the conflicts arise and, thus, save tremendous time, pain and expense. Moreover, well-constructed buy-sells can protect both individual shareholders and the business by providing a way to achieve liquidity while keeping demands for funds manageable.

The specific provisions of your buy-sell agreement are less important than ensuring that you have one, now, before conflicts arise and make productive negotiation impossible.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.