How to structure an effective buy/sell agreement for your business

It sounds preposterous, right? “Couldn't happen to me,” said Jim. He and his business partner, David, were both in their mid 40s and were lifelong friends. They were best man in each other's wedding and had been in business since college with the auto parts manufacturing business they had built that now employed 65 people and produced more than $18 million in annual sales. Then the unthinkable. David had a major heart attack while running and died. REALITY SETS IN Suddenly, the company not only lost its best salesperson, it also lost its emotional leader. David's homemaker wife, Kay, and their three young children needed to be cared for and personal savings were modest, as Jim and David had nearly all of their money in the company. David had negotiated most of the company's biggest contracts with the major auto companies and losing him could put some of the company's future contracts at risk. Recently, the company had borrowed $5 million to purchase new machinery to win a new contract with their biggest customer. David had been negotiating an extension of that contract when he died. Jim's role as operations and finance chief meant he had little involvement in the company's marketing and sales efforts. FOUR OPTIONS In addition to continuing operation of the business, Jim was had four other options: sell the business to Kay; buy the ownership interest from Kay; find an investor to buy out Kay's interest or sell the business outright. For various reasons, none of these options made sense, so Jim decided to continue operating the business. But he had a lot of changes to implement. THIN LINE BETWEEN FRIENDSHIP AND FINANCES Despite the anguish over losing his best friend, Jim had to keep the business running. He immediately needed to hire a full-time salesperson to assume David's role and absorb the continued cost of paying 50% of the dividend income to Kay, as she was now a 50% shareholder of the company. Over the next few months, revenue fell below expenses, largely due to the loss of the contract David had been negotiating, and the bank that had financed the new equipment needed to fulfill that contract was seeking more restrictive terms. This added up to negative cash flow, and Jim needed to suspend distributions. Kay did not understand why Jim would do this to her. The business had provided steady income for years, even through tough times. A week later, Jim received notice from Kay's attorney that she was suing the company for 50% of its last appraised value of $15 million dollars. It's a sad, but not uncommon story and could have been avoided with some straight-forward planning. BUY/SELL AGREEMENTS Had Jim and David developed an effective buy/sell agreement, they could have protected the surviving partner and their families by establishing the terms and timing of a sale arrangement at a pre-determined price in the event of the death of either owner. There are multiple ways to structure and fund a buy/sell agreement. Each of them has advantages and disadvantages in tax planning, asset protection, cost and ease of management, depending on your ownership type and personal preferences: 1) Regularly update your valuation. Buy/sell agreements are often created when a company is young. As such, it is common to see agreements with a sale price well below the actual value of the company. Updating this valuation every two to five years can prevent unintentional mispricing and potential litigation from heirs. 2) Be certain your terms of sale are clear and appropriate. Most buy/sell agreements fall into one of two categories: A mandatory sale or transfer of interest, which assures that control stays with the surviving owner as the heirs must sell the ownership interest and the surviving owner(s) must buy it. A put agreement would allow the ownership interest to be either retained or sold by the heirs. 3) Adequately fund the agreement. Even more common than failing to draft a buy/sell is the failure to adequately fund the terms of the agreement. There are four basic ways to fund the buy/sell: • Set up a sinking fund and pay into it over time. This requires the business to set aside high levels of cash every year. • Borrow the money at death. Unless the company has superior cash flow, most financial institutions hesitate to lend to a company where one of its owners has recently died. • Make installment payments to the heirs. If cash flow is sufficient to support it. • Life insurance. In most cases, may be the most logical option because the proceeds are delivered at the precise moment they are needed — and they are provided income tax free. In addition, the cost can be minimal compared to other methods. No matter how you ultimately decide to fund the buy/sell agreement, there is no doubt it is better than being in business with your dead partner's wife's attorney. Stephen Sherline is market leader for the private client reserve of U.S. Bank in Los Angeles.