So you are starting a new business and you and your partners are really excited about the endless possibilities that await you. The last things you want to think about are the worst-case scenarios, such as the death or a personal bankruptcy of your business partner. Have you considered how such unexpected events would impact your business, and how you will have to pay off your partner’s heirs or creditors to keep the business operating?
In New York, many individuals have ownership interests in small businesses that they have built up over the years. Quite often, they are started by family members or friends who join together to pursue the American dream. The demands of these businesses require hard work and great sacrifice. For legal purposes, they take the form of partnerships or closely held corporations. As the business grows and the years go by, it is common to find that the partners do not plan for or address how a change in circumstances will affect the business. For example, if one partner unexpectedly dies, the remaining partner would in most cases wish to continue to own and operate the business. The same concerns may arise when a partner becomes permanently disabled. In these circumstances, however, without the existence of a specific partnership agreement, the law may dictate that the partnership is dissolved, and that the interests of the disabled or deceased partner would have to be bought out by the surviving partner. If the surviving partner could not afford to make such a payment, then such circumstances may force a sale of the business. To avoid this drastic result, it is important for businesses to anticipate and plan for such events in a manner that is affordable and fair to all parties, through the drafting of a buy-sell (also known as a buyout) agreement.
What is a buy-sell agreement?
A buy-sell agreement is a useful tool to ensure the orderly transfer of ownership interests in a private business. It prevents serious business and personal discord. The agreement states the terms under which the remaining owner, or even the business entity itself, will buy out the interest of a deceased co-owner. It can preserve continuity of ownership and makes sure that everyone is fairly treated, buyers as well as sellers. It allows the business to continue to be run by the remaining partners. It serves as a contract that will prevent an argument over whether you can buy out the departing partner’s ownership interest, for how much, and it sets forth the method of payment. Generally, the agreement is funded by life insurance policies on each of the partners with proceeds to be paid to the surviving partner or the business. These proceeds are thereafter distributed to the estate of the deceased partner in exchange for that partner’s interest in the business, in according to the terms of the agreement.
Similar arrangements may protect against long term disabilities that can sideline one of the main players in the business. A disability policy can provide needed funds in the event of such an incident and buy out interests of someone who will not be able to return to the business for a long period of time.
What can a buy sell agreement accomplish?
A buy-sell agreement funded by life insurance or disability insurance can accomplish the following:
- Help to eliminate potential lawsuits stemming from the valuation of the business and the price to be paid to the estate of the deceased partner.
- Help assure the continuation of the business for the remaining partner(s).
- Allow the surviving partner(s) to maintain control of the firm by requiring the deceased partner’s interest to be sold.
- Help assure that the partner’s heirs are quickly paid in full for their share of the firm.
What specific circumstances should a buy-sell agreement cover?
A well drafted buy-sell agreement should cover the retirement or resignation of a partner, an attractive offer from an outsider to purchase a partner’s interest in the company, a divorce settlement in which a partner’s ex-spouse stands to receive a partnership interest in the company, the personal bankruptcy of a partner, or the disability, death, or incapacity of a partner. It should also specify whether a departing partner must be bought out, what price will be paid for a partner’s interest in the partnership, who can buy the departing partner’s share of the business (this may include outsiders or be limited to other partners), and what other events may trigger a buyout. The agreement should also include provisions relating to how the business is to be valued, how the buyout is going to be funded (i.e., through insurance), and under what circumstances you may invoke the agreement (i.e., death, and specified disabilities).
How can the value of the business interests of a partner be established in a buy-sell agreement?
An important component of the partnership (or buy-sell agreement) is the valuation portion of the contract. Not only does this need to be established during the early planning stages of a business, but it should also be reviewed on an annual basis. The simplest form of valuation to use is a multiple of total revenue. For many small businesses, this is the best option to use when setting up your initial agreement. Not only is it easier to agree upon a fair calculation, but there is less room for subjective or questionable amounts to be produced.
For example, if at the end of the first year your business had gross sales of $500,000 and you agreed that you would use a multiple of two for valuation purposes, then the company has a stated value of $1 million. This may not have anything to do with the true market value of the business, but it should, as closely as possible, match your best estimate of the market value for your business. As the company grows and additional shareholders become involved, you may want to consider a different approach to the valuation within your agreement. As long as all partners agree, this can be changed at any time. If fundamental changes occur in your business, you can always update this valuation to reflect the current situation. This is especially important when experiencing fast growth or bringing on additional partners or shareholders.
As your business becomes more complex, so may your valuation terms. You may prefer to create a formula that uses a multiple of earnings to value the business. The stock market is a prime example of this type of valuation, also referred to as “market value.” You will often see a reference to the PE (Price to Earnings) ratio when looking at the price for publicly-traded stocks. This is no different from creating your own PE ratio to value the business. You are simply stating the exact formula to use, since an open market for your shares does not exist within a privately-held company.
There is no right or wrong way to value the business in a partnership agreement. It just needs to be clear, so that it cannot be questioned should you need to use it in the future. Ideally, it should include an easy-to-understand formula or calculation on which all the partners agree. This can be as simple as a multiple of revenues, multiple of earnings, multiple of actual book value or net worth, or anything else that can have a value associated with it. If there is no agreement in place, however, it is likely that the surviving partner and the family of the exiting partner will disagree on the value, and this could result in costly litigation to resolve the issue.
Determining the valuation for the business within a partnership agreement is meant to protect the business from an unexpected change in ownership. Since this is an internal document, it does not have any impact on the valuation of the business outside of the partnership, should you and your partners want to sell the business to a third party. The true market value of any business is simply the amount someone is willing to pay for it.
What steps do I take to implement a buy-sell agreement?
Buy-sell agreements are technical legal documents that should be prepared by an attorney after a consultation. By taking these steps, you and your partners, along with your families, will gain greater confidence and peace of mind as you continue to grow your business and look toward the future.