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Buy-Sell Agreements – Continuity at the Top
Let’s say you and your partners have a thriving business, call it WidgetAmerica LLC. Each of you owns a good part of that profitable company, making good money and reinvesting in the business to keep things going well for years in the wild world of widgets. Then something happens, you retire, or something catastrophic happens—car accident, coma, death, incarceration—something that takes you away from the company and everything; Something that will force you (or your heirs) and your partners to make some tough decisions.
One way to ease this uncertainty and time of trouble is to establish a buy-sell agreement. Essentially, the agreement states that the other partners or co-owners must buy your stake in the company if a “trigger event” occurs, such as death, disability, retirement or some other specified event. You’ll be paid a fair price for your share of WidgetAmerica—as defined by the purchase-sale agreement—which could mean you’ll have income for retirement or cash for your heirs.
Of course, if one of your partners triggers a deal, you will have the opportunity to increase your own stake in the widget business. You can also take over the company. Either way, you’ll be able to do this without any annoying interference from surviving children or spouses. A buy-sell agreement between partners keeps the business between the partners.
Drafting your purchase and sale agreement
There are two ways to structure your purchase and sale agreement, each with its own benefits and liabilities. The key to choosing one of these structures is to consider the tax implications of each option.
Cross-purchase purchase-sale agreement
The remaining owners are required to buy-out the departing owner’s interest in the company. The purchase gives the surviving partners a 100% interest in the company. Partners also have a basis in the shares of the departing partner. This is called Aadhaar “step-up” and if they sell those shares in future, their tax liability will be reduced.
Redemption Purchase Agreement
In this type of buy-sell agreement, the company buys the shares of the departing partner, rather than the other partners. When a company buys stock instead of other partners, that stock is not reissued, meaning that the remaining partners have the same 100% stake in the company that they would have with a cross-purchase plan. The difference is that these partners don’t spend any of their own money and don’t get the basic step-up tax benefit.
IRS Issues and Right of Refusal
You can’t believe that the IRS doesn’t take an interest in this small transaction. If it is not done correctly, the money can be treated as a type of taxable dividend. However, this is not inevitable. You need a solid valuation of the company and a plan to anticipate tax pitfalls and change contracts to avoid them.
Valuation of the company
The first thing you need to do is determine the actual fair market value of your business. The price at which the company will change hands between a willing buyer and a willing seller, both have all the relevant facts and neither is under any compulsion to complete the transaction.. There are a few ways to do this:
- book value. Also known as the net asset value method, this valuation method is based on the net worth of the business (assets — liabilities) on the company’s books and records for accounting purposes. This is a fairly easy value to arrive at, however since it is based on historical pricing principles, its accuracy may suffer. There are two types of this method: tangible book value, which is based only on tangible assets; and financial book value, which requires an appraiser to update the property value to current market value.
- Capitalization of Earnings. This method is based on an estimate of the acceptable rate of return on investment against the risk associated with that particular business. This estimated rate of return is then applied to the expected revenue stream of the business based on the company’s average net income over the past few years. Potential buyers look for higher rates of return than they would expect from instruments like certificates of deposit or blue-chip stocks, where yields of 20% or more are common.
- Discounted cash flow. This method adjusts earnings for all non-cash expenses (eg, depreciation, amortization, gains and losses) and subtracts reasonable amounts of these expenses for future capital expenditures and liability payments to project future net cash flows over a period of time. The acceptable purchase price is determined using an approximate discount rate on term and present-value concepts.
- Sales-Multiple Appraisals. This method is commonly used to determine fair market value for service businesses with few, if any, tangible assets. It works by adding an industry-specific multiplier to the average earnings stream over several years. These formulas, however, do not take into account company-specific conditions. Therefore, if a particular business being considered for purchase has a location that differentiates it from the industry average, the multiplier may not be appropriate. Variations in this technique can be based on gross margin or net profit multiples.
Right of First Refusal
No matter how important you are to the business, you still need a level of flexibility to be able to negotiate the best deal for all involved. Perhaps the easiest way to do this is to give the remaining partners the right of first refusal. This gives the partners the right, but not the obligation, to buy out the exiting partner’s share in the business. If they choose not to exercise that option, the company itself is obligated to purchase the shares.
By doing things this way, the rest of the partners chose the way they should go. They can buy, step up and enjoy tax benefits; Or they can let the company buy, thus avoiding potential taxes on constructive dividends. The point is that either way, there are tax issues. By including a right of first refusal in the buy-sell agreement, the remaining partners will have a choice as to what tax issues they face.
A carefully planned and well-executed buy-sell agreement can ensure continuity in both ownership and management regardless of unforeseen circumstances. Setting one up, however, requires a lot of attention and should not be done without the services of a good tax accountant to prepare the agreement and navigate through the tax implications that the partners and the business may face. Yes, it will cost a little more now, but a good buy-sell agreement can save you more.
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