Constructing a building from scratch without a blueprint is similar to having a company without a strong buy-sell agreement. A buy-sell agreement in the construction industry is entered into by owners of a business and describes how ownership transitions will take place upon the occurrence of certain events. This takes going through a careful thought process that considers what could, might or will happen. Transition in ownership can transpire under many different circumstances – some positive, some negative. These circumstances are known as “triggering events.”
Do you want your partner’s spouse to help run your company? Do you want the bank to own part of your company, if your partner files for personal bankruptcy? Overlooking the importance of a buy-sell agreement could have unanticipated consequences such as the aforementioned, and create conflict that was not intended.
Even with substantial consequences to the value of a business, having a buy-sell agreement is not a priority for many business owners. According to Forbes, “nearly three out four business owners lack documented succession plans. With the government estimating that nearly 52 percent of business owners are over the age of 50, that’s a lot of companies with the potential to be thrown into chaos and lost value upon the death of an owner.”
There are two basic types of buy-sell agreements in the construction industry, a cross-purchase agreement and a redemption or liquidation agreement. In either situation there are appropriate steps a business owner can take to make sure they have a solid plan for the future.
- Develop your buy-sell agreement early. This should be developed well before it is needed. In some of the most popular cases of planning done right, Apple and IBM stand out. They both developed their plan, and started implementation when the company was strong and steady. Their transition in ownership did not come because of a mistake or shaky numbers, but it was rather a planned out, smooth transition.This also helps with the emotional impact. Outlining an agreement at a time when it is part of the business plan, rather than due to an “event,” allows for emotions to be less at play. People are focused on the agreement, rather than how it is directly impacting them in the moment.
- A key factor is determining the value of the ownership interest to be purchased or sold. Utilizing a business valuation expert may be in the best interest of the company, and valuation methods matter. To save money many companies develop their own pre-determined formulas and incorporate them into their agreements. However, this can have a much greater cost in the future, because it may not reflect the true value of the business at the time it is applied.
An example of this – Two business owners decided to set the company price at net book value plus $100,000 upon occurrence of certain events which are outlined in a buy-sell agreement between the business owners. When one partner died, the surviving partner was able to acquire the ownership interest for $250,000, even though the fair market value had grown to several million dollars. This left the family of the deceased partner with significantly less than the portion of the business was worth.The language used when crafting this piece of the buy-sell agreement is critical. It sets forth the purchase price for the departing owner’s shares, and ideally prevents conflict, and possible litigation over share value.
- Purchasing party has to have the ability to “purchase.” Many agreements outline the requirement that whenever a triggering event occurs, the business or owners will have the cash needed to buy out the ownership interest. Many times this can be set up with thought out life insurance policies on the owners of the business.
- There are tax implications. These can be structured to minimize tax exposure, or allow for tax payment over time. If an owner has most of his or her wealth inside the business, they (or their family) could be in for a big surprise if they don’t partake in tax planning, when setting up a buy-sell agreement.
- Review every few years. Utilize an outside resource to estimate the value of your company every few years, and review it as a management team often. This can reassure all the owners, that the company is still on track with the original buy-sell agreements. Circumstances within a company often change. Your buy-sell agreement should take all company changes into consideration.
There are many business planning tools, and buy-sell agreements are one tool in a business owner’s toolbox. Being a business owner is hard, yet rewarding work. Planning early on helps a business owner have confidence they have done their due diligence to have a plan for the unexpected situations that may arise.