Creating and operating a business usually starts with a great idea, capital investment by one or multiple owners, and hard work. While the main focus of an owner should be on day-to-day operations, there are always items that should be in the back of their mind for events down the road. For example, an event that can significantly affect a business’ course is the owner’s departure. This event can put a business’ future at risk. To mitigate this risk, an effective and well-planned buy/sell agreement is crucial.
This article will lay out how to properly design and implement a successful continuation or buy/sell agreement for companies that operate in the manufacturing industry.
What is a Buy/Sell Agreement?
A buy/sell agreement is a formal contract between business owners that provides a map for what will happen to each owner’s share of the business upon a triggering event. Triggering events include:
- Bankruptcy of a shareholder or member
- Loss of a professional license
- Termination of employment (you must distinguish with or without cause)
- Third-party offer to purchase the business
- Voluntary sale
A properly structured and funded buy/sell agreement enables a smooth transition of the business and helps answer questions of:
- How does the business plan to continue?
- How will the buyout of the departing owner be financed?
- Is there any plan for the family of the deceased or disabled owner to get involved?
- Who will have control of the business?
A buy/sell agreement provides a guaranteed buyer for an owner’s shares and protection for the remaining owners from the sale to an outside party. The contract will set a fair selling price. The price can be fixed or determined by a formula or a third party. The agreement will ultimately lay out the plan to liquidate ownership and facilitate a buyout. The risks of not having a buy/sell agreement are unlimited.
Types of Buy/Sell Agreements
Several types of buy/sell agreements exist; here are the main types and how they work:
- Cross-purchase – This type of agreement is between an individual and the other individual owners in the business. The remaining individuals agree to pay the owner or their estate an agreed-upon value or an amount based on a method of determining value.
- Entity purchase – This agreement is between an individual and the business. The business agrees to pay the owner or their estate an agreed-upon value or an amount based on a method of determining value.
- Wait-and-see – This is a hybrid between the entity and cross-purchase approaches. It lets the business owners wait until a triggering event occurs and decide whether the business or the owners should purchase the interest. It generally gives the company the right of first refusal.
Business structure (C corporation, S corporation, LLC, etc.), number of owners, and life insurance ownership structure should all weigh into the decision about which type of buy/sell agreement (as noted above) to use.
How to Fund an Agreement
Buy/sell agreements are most effective if a plan adequately funds the transfer of ownership. The ultimate goal is to find a way to support the transaction, so there is no financial hardship to the parties involved. Plans are usually self-funded, company-funded, or funded with a life insurance policy.
A life insurance policy is often used to fund a buy/sell agreement because it provides immediate liquidity to pay for a shareholder’s ownership upon death. This ensures the estate or family will receive a cash inheritance while allowing the business to continue running without taking on a substantial financial burden.
Other ways to fund a plan include:
- Using cash from the current operation’s working capital.
- Borrowing from a third-party lender.
- Utilizing a sinking fund.
Each funding mechanism has its pros and cons and should be examined carefully.
Determining a Value
In a well-planned buy/sell agreement, a section should be laid out on how the value of an existing shareholder’s interest should be determined. The contract will ideally set a fair selling price. Below are various ways a value can be defined:
- Appraisal — this option requires the use of a third-party business valuation professional. This form of value will likely come the closest to true fair market value.
- The downside of this avenue is that it will come with a cost and can delay the settlement process. When planning a buy/sell agreement, this method is most recommended. It creates the most flexibility and can ensure a fair value is paid to the departing shareholder.
- Book value — this approach ignores the entity’s earnings potential or growth.
- Capitalization of earnings — this value is determined by multiplying earnings by a capitalization factor, generally obtained by analyzing the price-to-earnings ratio of comparable businesses in the same industry.
- Many buy/sell agreements will use some form of multiple as it relates to earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Fixed price — this should be adjusted at a minimum on an annual basis or when a significant event changes the company’s value.
- Formula — this can be a combination of book value and capitalization of earnings or other reasonable methodology to determine a value.
For a buy/sell agreement to be effective, you need to review it periodically and, if necessary, modify its language to reflect changing circumstances. The business owners’ primary focus should be regularly challenging and adjusting the valuation provision.
Review your Agreement
In conclusion, an effective buy/sell agreement should be reviewed and, if necessary, revised regularly. A successful business is constantly changing and looking for ways to improve, so a well-planned buy/sell agreement should follow suit.
A buy/sell agreement solves problems before any potentially contentious times in the business. For further information on our business advisory services, please contact us at [email protected]. We can help assess your situation and determine the best way to proceed.