It’s one of the questions that new business partners most commonly overlook: What happens when one of the owners leaves the business?
For example, let’s assume that two people open a restaurant together. Ten years later, one of the owners becomes disabled and can no longer work. What happens in terms of the ownership and management control of the business?
Absent a thoughtful plan, developed from day one of the business, this type of not-uncommon scenario can lead to dispute and in many cases the demise of the business.
The solution is having a well designed buy-sell agreement in place that establishes processes and procedures for dealing with things like the death, disability, retirement or other departure of an owner from a business.
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract, often made part of an operating agreement or bylaws, that governs how an owner’s share of a business may be reallocated. It enables succession planning when certain triggering events require a business owner to sell, or offer, their ownership interest in the business to their co-owners.
The price to purchase the business interest is often either fixed or based on a fair market value formula. A buy-sell agreement will contain payment terms specifying the installments, interest, and any deposit required for the purchase of the interest.
A buy-sell agreement can take a variety of forms, including a wait-and-see plan, a cross-purchase plan, or a stock-redemption plan. For the wait-and-see plan, upon the occurrence of a triggering event, the other owners mutually agree upon who will purchase the interest of the departing co-owner. A cross-purchase plan involves the agreement of the surviving owners to purchase the interest of their co-owner. In the event the buy-sell agreement comports to a stock-redemption plan, the company buys the departing owner’s interest.
Putting in place a buy-sell agreement is not difficult, but it does require the co-owners of a business to think through various scenarios and make decisions on preferred outcomes in order to implement a mutually agreed upon and beneficial business succession plan.
How is a Business Valued?
One of the key provisions of a buy-sell agreement is determining the amount to which a departing owner should be entitled. There are several methods to accomplish this, but all involve establishing a valuation of the company.
Some of the common methods for determining the value of a business for purposes of a buy-sell agreement are:
● Establishing an agreed upon price among the owners
● Using a formula, such a multiple of revenue
● Hiring an appraiser to determine the fair market value of the business
Each method has its advantages and disadvantages. For example, while establishing an agreed upon price among the owners is relatively easy, it is unlikely that the actual value at the time of departure will be consistent with the agreed upon price. And while an appraisal method will almost certainly result in a valuation closer to the fair market value of the business, appraisals can be costly.
In most situations, it’s best to establish a valuation method that accurately reflects the business’ value, such as a formula or appraisal, because failing to do so may lead to expensive litigation.
Once a value of the business is determined, the amount a departing owner (or their estate) is entitled to is based upon their ownership percentage in the business. For instance, if an appraiser determines that the business is worth $1 million, and a departing owner owns 25% of the business, their payout would be $250,000.
How Are Payouts Funded?
To build on the previous example, a buy-sell agreement must spell out how the $250,000 gets paid out. This requires consideration of both the terms of payment and the source of funds.
For many businesses and/or purchasing owner(s), it’s not feasible to pay for the departing owner’s interest in one lump sum. Accordingly, many buy-sell agreements provide for the option of paying the purchase price over time (typically with interest), or provide that the company may elect to pay immediately or over time.
To the extent a buy-sell agreement requires an immediate payment of the full purchase price, a loan may be required to complete the purchase. Many buy-sell agreements provide that a business will obtain life and/or disability insurance on each of the owners, the proceeds of which are used to fund the payment upon the death or disability of the departing owner.
What About a Single-Owner Business?
For businesses with a single owner, such as a single-member limited liability company, the owner’s interest will, upon his or her death, generally transfer in a similar fashion to the decedent’s other assets.
For example, if the owner’s testamentary will directs his/her assets to be passed down to heirs, this transfer will include the membership interest in the LLC. In certain circumstances, this result is not ideal as it can take time for the will to be probated, during which the goodwill and success of the business may be in jeopardy due to lack of operation. If, on the other hand, an LLC’s operating agreement contains a transfer-on-death clause indicating to whom the membership interest shall be transferred, there will be no need to go through probate as the transfer will happen immediately upon the death of the owner.
Business owners in Michigan must expect—and plan for—the unexpected. One important step that every business should take, particularly businesses with multiple owners, is having a well designed buy-sell agreement in place. At Dalton & Tomich, we help Michigan small and medium-sized businesses and their owners create effective operating agreements which include buy-sell agreements. If you require helping in incorporating a business, creating an operating agreement, or have questions about your existing operating agreement, please contact Zana Tomich, co-founding partner of Dalton & Tomich.
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