Business Succession-Buy-Sell Agreements Family Businesses Must
There’s a saying that sums up the precarious nature of family businesses: “Shirt sleeves to shirt sleeves in three generations.”
In fact, financial advisers estimate that 65 percent of family businesses fail in the first generation and more than 90 percent bite the dust in the second, leaving the third generation to roll up its shirt sleeves and start from scratch.
The reason? Human nature plays a big role. Typically, the kids, having enjoyed the fruits of Mom and Dad’s success without appreciating the hard work behind it, lack the creativity, dedication and vision to carry it forward.
But failure to plan for transitional life events—the death, disability, divorce, withdrawal or retirement of an owner—can not only topple a business, but fracture the family as well.
There is a powerful preventative measure that can preserve a family’s love and livelihood: the buy-sell agreement. In it, owners specify a course of action when a “trigger event” such as death, divorce or a withdrawing partner places a business’ ownership, or even its continued existence, in jeopardy. The agreement is often included as part of the company’s overarching operating agreement.
Contrary to what you might expect, a typical buy-sell agreement is designed to prevent, rather than facilitate, the sale of a business. Here, buy-sell refers instead to how an owner’s shares may be sold, to whom, and at what price, upon his or her departure.
Think of it as a prenup for businesses. And, just as with marital prenuptial agreements, family partners are often skittish about drafting one. It seems cold, calculating and counterintuitive to discuss family members or spouses in a business context, much less one that includes your own demise. That’s right, all the fun of a prenup and a last will and testament rolled into one!
Who needs it, right? You do, if you’re in business with your family or stand to inherit property in co-ownership with your siblings.
“It’s quite important,” says Randy Fairfax, a fee-only financial consultant with Highland Consulting Associates in Cleveland. “Because sometimes they don’t keep hugging each other.”
Buy-sell agreements are as individual as snowflakes, no two quite alike. But they tend to have these features in common:
1. Statement of purpose
What is most important to you as owners? Do you want a nice income stream for retirement or will you plow profits into the company for the next generation? In all likelihood, the purpose of the business founders and the second and third generation will differ markedly. The key is to arrive at a purpose for the business that all parties can live with. Much of the rest of your buy-sell agreement will hinge on it.
2. Restrictions on ownership
Here’s the delicate part. Some families choose to limit ownership or controlling stock, say, to bloodline descendents, meaning spouses are excluded.
Steve Faulkner, national managing director for JP Morgan’s closely held asset management and valuation advisory services group, says that’s not as cold as it sounds. It’s important to distinguish between participating owners, whose function is key to the health of the business, and nonparticipating family members who merely receive a share of the profits.
Next: Succession to spouses generally hurts a family business.
“If one of the 50-percent owners dies or becomes incapacitated, that doesn’t mean that the spouse is then entitled to suddenly become an employee and draw that same salary,” he says. “By creating this buy-sell agreement, you’re actually protecting that nonparticipating spouse who otherwise could end up with a 50-percent interest in a company that doesn’t distribute much income and has lost its livelihood.”
Fairfax agrees that succession to spouses generally hurts a family business.
“Usually they are not involved with the day-to-day operation of the business, so it usually creates a negative. The spouse has a lot of emotion and a lot of security needs that all come from the business. From a good planning standpoint, having them have the stock probably in the long run leads to those failure rates in the first and second generation.”
Clearly spelling out who can and cannot sell or acquire stock can protect your company from drifting into mismanagement by those not intimately involved in the business, as well as from claims by divorced spouses, step-grandchildren and widowed in-laws.
1. Trigger points
Just what are the trigger points that will create a liquidity situation for the company? Death, disability, divorce, retirement, withdrawal and even termination is common. At these junctures, somebody will want cash in exchange for his piece of the pie. Without proper planning, a business could find itself faced with a limited number of options, all of them bad.
“It’s tragedy sometimes,” says Fairfax. “You now have a brother who is suddenly in partnership with two sisters-in-law and works his tail off. He’s 73 years old, he has great buyers for this thing, and he still doesn’t have the ability to sell and has to keep working his tail off to support these two sisters-in-law who are now remarried. It does not lead them to have great times together. He keeps trying to persuade them to sell, but from their perspective, why should they? They’ve got it made.”
An effective buy-sell agreement will make certain that for each trigger point, the company will have its first and best choice of options, some of which are discussed in buyout financing below.
“You design trigger points so that you can exit the business and have cash in what otherwise is a very illiquid asset,” says Faulkner.
2. Valuation
When a share buyout is triggered, it is important to have agreed beforehand on a method to arrive at an equitable estimate of the value of the business. Some closely held businesses reassess the business on an annual basis and agree to use that figure for the next 12 months. Others agree to bring in independent appraisers on both the buy and sell side and split the difference. Still others may use more sophisticated valuation formulas that factor in ratios of price to earnings or actual book value.
“Here’s where you’ve got to look at the objective of all this,” says Faulkner. “Is it to maintain the business within the family? If so, you may not want to get the highest and best value because the business may not be able to pay the same price that a private equity fund or a strategic buyer could pay.”
Next: Keys to buyouts include….
By the way, there is another party that will be very interested in your valuation method: the Internal Revenue Service. The tax man has made it clear under Treasury Regulations Subchapter B, Section 25.2701-1 and 25.2701-2 that it will watch much more closely the valuations of a buy-sell agreement if the participants are related.
1. Buyout financing
Buyouts can place serious strain on a business’s reserves and force a closely held business into unattractive alternatives. That’s why many family businesses use life insurance to secure control of the company on the death of an owner. Essentially, if the value of an owner’s share is estimated at $5 million, the company takes out a $5 million policy on her that names the company as beneficiary to fund the buyout at death.
What many buy-sell agreements fail to take into account is the far more likely scenario that an owner will become incapacitated for the short or long term. In these instances, a mere life insurance policy won’t be much help.
“You’re in a very big Catch-22 because morally you don’t want to hurt your spouse or sibling, you all built this together, but practically the business can’t afford to keep paying him and get a person of his skills and abilities,” says Fairfax. “So the business is going to keep going down, which of course lowers his value, but you don’t have the cash flow to buy him out. It can get to be a very ugly picture.”
Keys to buyout financing: Include disability insurance, establish a schedule a payments over time and rather than a lump-sum payout, agree to one-third or one-fourth down. That way, the business won’t be forced into unseemly circumstances. Also, consider discounts to the payout amounts for such things as lack of marketability and lack of control; after all, the company deserves some compensation for its loss of a key owner.
Important addendums
Faulkner notes a couple important addendums that many businesses overlook when drafting a buy-sell agreement: a noncompete clause and a look-back provision. The noncompete clause prevents one of your family members from taking his buyout and starting his own business in competition with the family business. A look-back clause protects a departing owner in the event that other family members secretly conspired to profit from his departure.
Faulkner has seen it happen:
“One of three siblings left the business, they abided by all the discounts, and six months later, the two other siblings sold the business at a high value where no discounts would have been applied. So the question came up: Was this contemplated at the time? Was this fortuitous timing? The skeptic in me says they probably knew of something on the horizon.”
Correctly executed, a buy-sell agreement can keep peace in the boardroom and in the family. It can even be a powerful management tool. One of Faulkner’s clients has a buy-sell that provides that when he turns 65, 30 percent of his stock will be distributed in bonuses to his management team, which previously had worried that the company would fall into the hands of incompetent heirs.
The best time to establish a buy-sell agreement? While Mom and Dad are still on the scene, or early on among the successor siblings, says Faulkner. “Typically, if it can be implemented at that earlier, transitional stage, it can have better outcomes,” he says.
But remember: Don’t shake hands on a buy-sell agreement without first running it by your accountant, your attorney and your financial adviser. There are important tax considerations that, if addressed upfront, can be as valuable over time as the savings from the buy-sell provisions themselves.
Reference: Jay MacDonald, Bankrate.com, January 4, 2006
Filed Under: Business Planning, Business Succession
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