10 Reasons Why You Must Have A Buy-Sell Agreement

Many family businesses operate informally, so it isn’t unusual to find successful businesses going for years without holding a board of directors meeting or operating without critical shareholder agreements. However, as the family business grows, or as the time for management transitions nears, it is imperative that certain agreements be implemented.

One of the most important is the buy-sell agreement. The buy-sell agreement may stand alone or be part of another agreement, such as an employment contract. Having a buy-sell agreement provides several advantages for your business.

1. Creates a market for closely held interests. Closely held family businesses don’t have a ready market. Thus, selling a portion of the ownership interest, particularly minority interests, is extremely difficult and valuation is subjective. Buy-sell agreements provide the selling party with certainty as to price and terms, and an understanding of a market for the ownership interest. At the very least, the buyer will have a right of first refusal with regard to that ownership interest in certain events.

2. Forces owners to address valuation and succession issues. Only when business owners meet to hammer out the terms of a buy-sell agreement can they come to grips with valuation and succession issues. To create a healthy and prosperous atmosphere, deal with these issues early, before family members become too deeply involved in the business.

3. Provides a framework for dealing with owner disputes. If no buy-sell agreement exists and one owner disputes how the business is managed, the result can be disastrous. The dispute could evolve into lengthy litigation, drained financial and emotional resources, and lead to the breakup of the business. The buy-sell agreement typically provides a way to deal with owner disputes, including arbitration and other ways of managing conflict.

4. Offers a way to prevent nonactive shareholders from entering the business. Without a buy-sell agreement, if an owner dies or decides to make a gift of an ownership interest to a family member, the family members who are active in the business may find themselves in day-to-day dealings with spouses and children who have no connection with the business. Owners and officers may wish to separate active family members from nonactive family members. A buy-sell agreement helps prevent conflicts that may arise.

5. Allows the founder or older generation to orchestrate future business management. Family business owners can communicate their visions to siblings and children, which can affect the choice of successor. Also, placing this vision of succession in a binding contract helps ensure that the business will carry on, to some extent, to the older generation’s liking.

6. Fixes value for estate tax purposes. A buy-sell agreement typically has a formula or other method for valuing ownership interests. If done correctly, and if the proper relationships are established between the parties, the valuation contained in the buy-sell agreement will fix value for purposes of taxing the estate upon its owner’s death. When the parties are unrelated, or distantly related (such as cousins), a formula in a buy-sell agreement must meet the following requirements in order to be respected for estate tax purposes:

• Be a bona fide business arrangement that is fair to the parties when entered into, and

• Provide a binding buyout price during lifetime and at death.

When a close family relationship is involved, the buy-sell agreement needs to be one into which a third party would reasonably have entered. In a close family relationship situation, it may be more difficult to fix value for estate tax purposes. Also, in a close family situation, the owner may not want to fix value in an agreement so other benefits such as minority discounts can be used advantageously.

7. Requires family business owners to deal with family dynamics. Family businesses are different from other closely held businesses because they employ people who are entitled to an interest in the business, and others who think they are entitled to an interest in the business. Sometimes owners are forced to deal with family members who, if they were not related, would never be a part of that business. The buy-sell agreement often provides the structure that sets the tone for family relationships in the business. In working out the provisions of a buy-sell agreement, these issues need to be dealt with before the agreement is signed.

8. Forces shareholders to deal with funding and liquidity issues. Family business owners often have impressive personal financial statements, but their net worth is tied up in a nonliquid asset -- the family business. When putting together a buy-sell agreement, one of the issues that must be addressed is how a buyout will be funded. Sometimes it is through the use of life insurance. Other times it is through accumulated earnings or seller financing. Regardless of the method used, owners are forced to deal with how shares will be bought out in the future.

9. Facilitates estate planning objectives. Typically, a family business owner spends a lot of effort trying to avoid estate tax. When estate tax is unavoidable, the owner must deal with estate tax payments. A buy-sell agreement can be structured to help minimize those estate taxes and may also be structured to take advantage of favorable redemption rules upon death.

10. Helps prevent loss of tax benefits. Particularly in S corporations, it is imperative that stock not be transferred to any person or entity that would cause termination of the S election. A buy-sell agreement typically restricts the ability of a shareholder to transfer shares outside of the current ownership group without consent of the other owners.

Buy-sell agreements are critical tools in preventing disgruntled shareholders from causing problems for the entire ownership group and in preventing transactions that inadvertently cause the loss of S corporation benefits. Using buy-sell agreements allows all the shareholders to think carefully before permitting a transfer outside of the ownership group. Whether you use a separate buy-sell agreement or make it part of another agreement, this is one agreement you won’t want to omit from any business deal.