By Mark Tepper
June 21, 2017
Imagine that on the eve of your wedding, you make a plan to divorce your spouse, on friendly terms, in about 15 years. During those 15 years, you agree to work diligently and successfully to build a business. On the preordained day that your marriage ends, you announce that you are willing to give your soon-to-be ex-spouse one-half of your company’s business value in cash. Additionally, you let your ex-spouse value your company, because those are the terms of the agreement the two of you signed a year after you were married.
Though this scenario may seem ridiculous, you may have done something quite similar in your business with your co-owners.
Few owners begin working together with an expectation of future acrimony, much less litigation. Fewer still give thought to one day leaving the business—even on friendly terms. Indeed, most exits are not precipitated by a disagreement among co-owners; instead, owners leave for a variety of reasons and simply want to do so with their share of business value.
Remember: One day, you will leave your business.
Over time, in business as in marriage, partners can grow apart. We’ve all witnessed the resentments, discord, and wastefulness of a friend’s needlessly nasty divorce. Business divorces can be equally unpleasant, but with an added twist: Owners may be unable to leave the business, or force a partner to leave, without appropriate tax and legal planning.
When an owner or co-owner wants out, what will happen? Chances are that when owners and co-owners turn to the company’s Buy-Sell Agreement, they will find that it is woefully out of date. They also may find that it controls the terms of their exits from their businesses not only upon death but also during the owner’s lifetime.
If you haven’t looked over your company’s Buy-Sell Agreement since you signed it, dust it off and check at least four key provisions:
- Lifetime and death transfers of ownership:
- When must an owner sell or offer to sell?
- When must a co-owner (or the company) buy, and when does the co-owner or company have the option to buy?
- How will the value of the company and the value of a departing owner’s interest be determined?
- Does the agreement mandate the use of an independently determined fair market value at the time of transfer? If not, the valuation will favor either the buyer or seller. It will not treat co-owners evenhandedly.
- What are the terms (length, down payment, interest, and guarantees) of the buyout?
We generally assume that Buy-Sell Agreements control the transfer of an owner’s interest when he or she dies or becomes disabled. However, they usually do much more, and if owners don’t appreciate how much more, disaster looms. Consider the following scenario:
At his annual physical, Steve Hughes complained that he was bone-tired. After a battery of tests, Steve’s doctor observed that, while there was nothing physically amiss, Steve did seem depressed. After some introspection, Steve was able to articulate that he had no interest in continuing as a partner in his successful CPA firm. Like many owners, Steve had lost the passion and commitment to the business that still stoked his younger co-owners. He decided to sell out before his partners demanded it.
Steve broke the news of his departure to his two partners and noted that their Buy-Sell Agreement controlled only a buyout at death and an option for the company to buy Steve’s stock if he were to sell it to a third party. Attempting to sell a partial interest to a third party is always a difficult proposition, but economic challenges made that course of action impossible.
Steve and his partners were left in a classic dilemma: The remaining shareholders wanted to purchase the departing shareholder’s interest so that future stock appreciation—due solely to their efforts—would be fully available to them. Conversely, because the profits of a closely held corporation are either accumulated by the company or distributed to the active shareholders in the form of salaries, bonuses, and other perks, the departing shareholder (now an inactive owner) rarely receives significant income in the form of distributions or dividends.
Naturally, Steve wanted and needed maximum value for his interest, while his co-owners were convinced that the company’s cash flow could not support Steve’s buyout.
In light of this scenario, owners must examine their business continuity agreements immediately: If the owner is the one leaving, is the agreement as fair as it would be if the owner were the one left behind?
When you sit across the bargaining table from your business partner(s) for the first time, you will want that table set with a fair valuation method, a thoughtfully designed lifetime buyout provision (that may well reduce the cash flow required for a buyout by 20–30%), and manageable payment provisions. Since it is exceedingly difficult to design these provisions when the buyer and seller are at the bargaining table, owners should agree to and document the valuation, cash flow, and tax and payment provisions long before potential discord and differences of outlook arise.
Your first step toward avoiding the problems described in this article is to conduct a thorough review of your business continuity agreement, and we are happy to help you do so. If you would like a more extensive checklist and additional information about this most important of all business documents, please contact us.
By Mark Tepper
June 7, 2017
There is a strong case for creating a Buy-Sell Agreement for co-owned businesses. If owners agree about how to appraise business value and set the terms of payment in advance of any transfer event, they can avoid the heated and often damaging negotiations that can occur when one owner leaves the company.
In this issue, we continue making our case for Buy-Sell Agreements by outlining several other advantages of a well-drafted and recently reviewed Buy-Sell Agreement.
A Buy-Sell Agreement can control all transfers of business ownership to the benefit of both the owner wishing to transfer ownership and the owners who want to acquire ownership. This agreement can assure that a selling owner (or his or her estate) is selling for fair value and under terms and conditions that are acceptable to all parties. Further, the agreement assures remaining owners that any transfers of ownership must be at least offered to them. This eliminates the potential for an outside party or a co-owner’s spouse or children to assume ownership of the business, all of which could negatively affect the company’s management, control, and value.
A Valuation for All Reasons
A Buy-Sell Agreement sets forth an agreed-upon method of valuing the business that applies to all transfers.
Owners’ valuations of their own businesses may be much different than the IRS’s or a co-owner’s. If owners rely on a “stated value” or a formula-based value, they may run into difficulties with both the IRS and other owners, because value in privately owned businesses changes often and rapidly. If Buy-Sell Agreements are not revised every year, their valuation formulas will favor either the buyer or the seller, and provide ample opportunity for disputes. Owners can avoid this by requiring a value determination from a certified business appraiser, but even that provision needs to be drafted carefully.
Similarly, if co-owners buy a living co-owner’s interest, the value of the selling owner’s interest will likely be lower in the buying co-owners’ opinion than the seller’s. However, if their Buy-Sell Agreement requires the involvement of a business appraiser, they can avoid this impasse.
It is best to agree—today—on a method of valuing the business when no owner knows which side of the transfer table he or she will be sitting on. Not knowing whether you will be a buyer or a seller tends to ensure that all owners work to protect the interests of both the buyer and seller.
If owners don’t have an existing, binding process for valuing the business, ideally using a credentialed business appraiser, they can expect disagreements when one of the owners leaves the business. We strongly recommend that owners take the reins and design a valuation appraisal process suitable for their companies, and we would be happy to help you do so.
The Fine Print
In a Buy-Sell Agreement, owners can fix the terms and conditions of any transfer of ownership, including interest rate, length of buyout period, and security. In addition, it often is possible to provide the funding for future ownership acquisition, either during an owner’s lifetime or after death.
Finally, Saving on Income Taxes
Buy-Sell Agreements should be drafted to anticipate the likeliest transfer event: the sale of an ownership interest from one owner to another. While they require additional planning and document drafting, intra-owner sales can be designed to save as much as 30% of the company’s cash flow from taxation. For example, if the purchase price is $1 million, the cash flow required to pay a departing owner could be reduced by $300,000 or more. To repeat, this does take additional tax planning—but the result is well worth it.
We’ve made our case about the importance of establishing a proper Buy-Sell Agreement, and now we want to help you do it. Contact us today and we can begin creating a Buy-Sell Agreement that covers all of your business wants and needs.
By Mark Tepper
May 24, 2017
How do you know the right time to sell your company? One answer to this age-old question is that the time to sell is when someone else is willing to invest more in your business than you are.
When you start a business, nobody is willing to invest in its success more than you. You’ve already worked a 40-hour week by Wednesday and, if you’re like most founders, you’ve invested a big chunk of your liquid assets to get your business going.
You’re all in.
In the early days, you are willing to risk your business on a new strategy because the business is pretty much worthless. As the Bob Dylan lyric goes, “When you ain't got nothing, you got nothing to lose.”
As your business grows and becomes more valuable, you may find yourself becoming more conservative, unwilling to risk the equity you have created inside your business on your next big idea. You have reached a point where someone else may be willing to risk more time and money for your business than you are.
Peach New Media
David Will is the founder of Peach New Media, which he started back in 2000 as a reseller of web conferencing. In the early days, Will changed his business strategy frequently, trying to find an idea with legs. After a number of pivots, he landed on selling learning management software to associations.
The business grew nicely and by 2015 Peach New Media had 40 employees and then received an attractive acquisition offer from a large private equity company. Will was conflicted. He loved his business and treasured the team he had built. At the same time, the acquirer was offering him a life-changing check.
In the end, Will realized that he had become somewhat more conservative as his business had grown and the potential acquirer was willing to make a big bet on integrating Peach New Media into another one of its acquisitions. Will realized he had reached a point where his appetite for risk in his own business was lower than his potential acquirer’s. Will decided to sell.
When To Sell
The point where a buyer is willing to risk more than you are happens at a different stage for everyone. Let’s say you have a business worth $1 million today. Would you be willing to risk the entire thing on a new strategy for a shot at making it a $10 million company? Many entrepreneurs would take that bet.
Now imagine you have a company worth $10 million and your business represents the bulk of your net worth. Most would argue $10 million is life-changing money. Would you be willing to risk your entire company for a chance to make it a $100 million company? The marginal utility of an extra $90 million is minimal—we all only need so many cars—but the risk is significant. Fewer owners would bet $10 million for a chance at $100 million.
What if your business was worth $100 million? Would you risk it all for a long shot at becoming a billion-dollar company? It is hard to imagine any one person betting $100 million dollars on anything, but if you’re the CEO of a billion-dollar corporation with ambitious growth goals, $100 million is a bet you may be willing to make.
When someone else is willing to invest more in your business than you are, it is probably time your company finds a new owner
By Mark Tepper
May 17, 2017
Contemplating one’s own demise can be challenging but is paramount to sole owners and their businesses. Consider the fictional Harry Withers, the 54-year-old owner of Withering Hikes, a chain of seven retail apparel stores for outdoor enthusiasts on the Western Slope of the Rocky Mountains. One day, Harry disappeared while scouting new hiking trails.
After several months of fruitless searching, Harry’s family opened probate proceedings only to find that Harry’s once-thriving business also had disappeared. However, Withering Hikes’s disappearance was far more typical than Harry’s. Because Harry had dreamed of selling his company at 60, he had given little thought to what would happen to his business if something happened to him. Thus, Withering Hikes died of all-too-common causes—human error and neglect—setting off a chain reaction of ever-worsening consequences for Harry’s family and business:
- Harry’s key employees left the company for jobs with more certain futures. They feared that neither Withering Hikes nor their salaries would continue without Harry at the helm.
- The departure of key employees meant that there was no one to manage the business. Total chaos reigned, and revenue took an immediate and irreversible nosedive. Longtime customers grew uneasy with what they perceived to be a rudderless ship and took their business to Harry’s competitors. Further, the company’s vendors demanded cash payments, cash that the company no longer generated.
- Harry’s bank saw the drop in revenues and decided to call in the company’s debt, debt Harry had personally guaranteed.
- Because Harry left no instructions or recommendations about who could run the business, who could offer advice, or even what to do with the business should something happen to him, both his business and family suffered.
Withering Hikes didn’t just wither away; it fell off a cliff. It could not survive without its top employees or Harry’s leadership.
The point of reviewing this list of mortal blows is to demonstrate that business-continuity planning is vitally important to owners’ companies and families. Without a well-considered business survival plan, the consequences for owners’ employees, customers, and, most importantly, family and estate are dire (estates rarely escape the notice of business creditors).
Fortunately, there is a process that sole owners can quickly and easily use to help avoid the type of business collapse that Withering Hikes experienced.
First, sole owners must motivate top employees to stay on after their demises by creating financially meaningful incentive compensation plans for them that vest over time. Creating a plan that provides these employees a substantial bonus (called a stay bonus) for remaining with the company beyond an owner’s demise is a strong strategy. The company can usually fund the stay bonus with life insurance on the owner’s life. This funded stay bonus provides designated employees with a cash bonus (usually about 50% of annual compensation) and a salary guarantee if those employees stay (typically 12–18 months) after the owner’s death. The sole owner’s job is to communicate these actions to these employees and assure them that he or she has made additional plans to ensure the continuation of the business.
Second, sole owners should alert their banks about their continuity plans. Meeting with a banker to discuss the arrangements made and showing him or her that the necessary insurance funding to implement these plans is in place can allow an ownership transfer to proceed smoothly. Additionally, it is wise to determine whether major creditors are comfortable with the succession plan. Sole owners should ask major creditors which arrangements they would like to see in place.
Third, create a written plan that does the following:
- Names the person(s) who will take on the responsibility of running the business.
- States whether the business should be continued, liquidated, or sold (if so, to whom).
- Names the resources heirs should consult regarding the company’s sale, continuation, or liquidation.
Finally, sole owners should work closely with a capable insurance professional to assure that the necessary insurance is purchased by the proper entity (the owner, the owner’s trust, or the business) for the right reason and the right amount.
Creating a contingency plan for your company should you depart unexpectedly is a vital part of your overall Exit Planning process. Failing to do so invites the kind of disaster that befell Withering Hikes, Harry’s employees, and his family.
Our expertise in crafting business-continuity plans that work can help you be prepared for the unexpected. Contact us today to learn more about how to begin creating a contingency plan for your solely owned business.
By Mark Tepper
May 3, 2017
If you co-own your business, the business-continuity agreement (or buy-sell agreement) is one of the most important documents that you will sign. If you have a buy-sell agreement that is out-of-date, not reviewed, or focuses on the wrong issues, it may be worse than having no agreement at all.
Let’s start with a hypothetical case study that illustrates the importance of drafting a buy-sell agreement that anticipates and provides for all transfer events (lifetime transfers, disability, or death).
George Acme’s son-in-law, Tom Gardner, had been with George’s company for over 20 years. Tom had gradually assumed an operational-management role, was the acting CEO, and had purchased 25% of George’s ownership over the years—mostly at a low value, in recognition of his valuable services. Everyone acknowledged that Tom would one day own the company and carry on Acme’s fine traditions.
However, that was before George died and Tom’s sister-in-law, Babette, became the executor of the estate. Babette told Tom that she would either sell him the balance of the company—at full fair market value and for cash—or would sell the business to the highest bidder.
Only later did she realize that without Tom’s cooperation, the business was unlikely to sell. No buyer wants a disgruntled minority co-owner, especially when he’s the current CEO.
Tom and Babette disagreed about the company’s value, who was in control, and successor ownership. All of these issues would have best been discussed and resolved before George’s death. Had Tom and George created a buy-sell agreement, the business would have transferred at a fair price to the benefit of all concerned. Now, because Tom and Babette weren’t talking—except through their lawyers—it was unlikely that Acme could even keep its doors open.
Lifetime or Death Events
The buy-sell agreement controls the transfer of ownership in a business when certain lifetime or death events occur. Typically, the trigger events include the death of an owner, a sale and transfer of stock from one owner to another, or a sale to an outside party. A buy-sell agreement can also describe owners’ agreements about how transfers will take place after lifetime transfer events occur, such as an owner’s permanent and total disability, termination of employment, retirement, bankruptcy, divorce, and/or a business dispute among the owners.
Assume George didn’t die. Instead, one of his co-owners wanted to exit. How would they agree on value and buyout terms or design the transfer? Without a buy-sell agreement agreed to in advance, one owner’s desire to exit can transform longtime co-owners into adversaries, based on disagreements about valuing the company and setting the terms of purchase. The buy-sell agreement sets the valuation method and the terms of the purchase, and outlines the tax plan.
A buyout during an owner’s lifetime is similar in design and consequence to the sale of the entire company to a third party. The value of the business and the terms of the sale (payment, security, etc.) will be negotiated. However, in internal transfers, hard-nosed negotiation tactics and disputes about value and payments can quickly destroy friendships, company culture, or even the value of the business.
The best way to avoid this is to agree in advance on the method of appraising value and payment terms when all of the co-owners are on the same page, looking out for the ultimate welfare of the company, and don’t know whether they will ultimately be a buyer or a seller. During each of these events, the buy-sell agreement may require the business or remaining owners to purchase the departing owner’s stock, give an option to the business or the remaining owners to buy that ownership interest, or give the departing owner the option to require the company to buy his or her ownership interest.
Remove the Guesswork
The buy-sell agreement should provide a clear picture to a departing shareholder regarding how much money he or she will receive and how often. Likewise, the remaining shareholders should know the extent and duration of their buyout obligations in advance. This allows both parties to plan their respective futures.
The buy-sell can and should establish the value of the stock, set the terms and conditions of the buyout, and give additional protection to all owners. In short, the buy-sell agreement is intended to protect all owners by telling each to whom they can sell, at which price, and under which terms and restrictions.
In This Case, Nothing Is Better Than Something
As we stated at the outset, an out-of-date buy-sell agreement is often worse than no agreement. Out-of-date agreements may require an owner to buy or sell based on inaccurate values or terms that may have made sense during boom times but can mortally wound the business in tough times.
We urge you to review your buy-sell agreement at least annually as part of your annual planning meeting with your advisors. At a minimum, ask the following:
- Does it reflect when I want to depart?
- Does it give me the amount of cash I need to be financially secure?
- Is it designed to minimize income taxes to the seller and the buyer in the event of any type of ownership transfer during my lifetime?
If your buy-sell agreement is well drafted and conscientiously updated for changes in ownership, value, and other circumstances, there aren’t many disadvantages.
We’d like to help you create and consistently update your buy-sell agreements to reflect your most current wants and needs. Contact us today to begin building a buy-sell agreement that can handle any kind of transfer event.