Transferring a family business through buy-sell planning
Most family business owners are very busy with urgent areas of their business: recruiting and retaining good employees, and keeping customers satisfied. Time and attention paid to a future question — “What happens to my business if I’m not here to run it?” — can positively contribute to each of those. This article discusses strategies for the family business owner who doesn’t intend to have family members inherit the business interest.
Just as an individual has a will to dispose of assets after death, a buy-sell agreement is a binding roadmap specifying the disposition of a business interest in the event of death, disability or retirement, providing a “market” for the family business interest. This can be crucial to the owner, primarily because the agreement is a blueprint of how the owner realizes cash from the business at disability, retirement or death. There’s no public stock market for a family business, so the buy-sell agreement can solve that problem. When family members are involved in the business, it is more important to outline succession in an agreement.
Issues the agreement addresses:
Management continuity: Whether the interest is sold due to disability, retirement or death, successor owners, who may be family members, are identified. The agreement typically will prevent the business interest from being sold to outsiders without the express consent of family members who are party to the agreement.
Converting the interest to cash: Next-generation owners can pay a stream of income to supplement the retiring owner’s other retirement plans; provide income to an owner who has succumbed to a disability; supply cash to an estate in exchange for the interest at death, which is very helpful since the Internal Revenue Service only takes cash for estate tax.
Business value: Rules governing the valuation of a business, particularly when family members are involved, are clear: The value must be fair market, reflecting an arm’s length transaction between parties not under a compulsion to buy or sell and who are in possession of all relevant facts. The agreement can specify the business valuation method used, such as a formula, which is followed and updated annually. Since the agreement is negotiated while all the owners are alive, it’s more likely they’ll arrive at a fair price.
Forms of buy-sell agreements
Most buy-sell agreements answer the question, “Who is buying?” If other owners purchase the interest directly, the agreement is called a “cross purchase.” With only one party, such as a key child buying, there is no “cross” to the purchase; it’s a one-way buyout.
If the business entity purchases the interest, the agreement is called “entity redemption.” Some agreements have characteristics of both, requiring the business to redeem the interest if the owners are first offered the right to purchase and they decline. That “first offer” agreement can provide flexibility at the time the interest is to be transferred, allowing the owners to “wait and see” which method works best at that time.
We have an agreement, now what?
If the purpose of an agreement is to provide a ready market, the owners should consider creating a funding mechanism. Face it: The agreement about valuation and responsibilities is terrific, but if no funding exists to execute the agreement, what was accomplished? There are four ways to fund a buy-out and none are mutually exclusive.
The first method is to use a sinking fund, where owners agree to set aside funds from their earnings. The fund will be subject to income tax as it grows and viable so long as there is plenty of time before the funds are needed for the buyout.
Second, owners can borrow cash, which involves interest and principal. Would creditors become concerned after the primary owner is out of the picture? Would a loan be made at all? Would the interest payments be at a premium? Would significant collateral be required to secure the loan? Could collateral requirements jeopardize other business loans or bonding requirements?
Third, the installment sale is a “fail safe” mechanism and is in virtually every buy-sell agreement. This allows the surviving owners to pay the departing owner’s interest over time, typically relying on distributions of profits to the owners who then make payments, or the business uses earnings to pay its obligation to the departing owner or estate. Consider whether allocating current profits to a buyout over time may place a strain on the business’s financial resources or whether the cash flow may prevent the successors from expanding.
Common to all three of these methods is trust. Regardless of the reason for leaving the business, the owner must trust the surviving owners to meet their obligations and trust the business will continue to grow and produce profits. If the departing owner has been the driving force in the business, there may be a question about how successful the business may be after his departure, which can cast a shadow on the business’ future success.
Finally, life and disability insurance can be used to provide funding. Most owners can determine when they want to retire, if ever. Two events which cannot be controlled are disability and death — uncontrollable, but thankfully insurable.
In a sense, a life insurance policy used to fund a buy-sell agreement is an asset, similar to a sinking fund, but allows growth on a tax-deferred basis and provides a lump-sum death benefit regardless of when death occurs, after one premium or after many.
A well-drafted buy-sell agreement can assure business continuity. Funding obligations under the agreement with life and disability insurance can bring peace of mind for the business owner. Trusting one’s children to carry out the requirements of the agreement contains an element of hope. Funding the agreement with life and disability insurance can put cash in the hands of the children, making it easier for them to fulfill their obligations to the departing parent.
Lynne Stebbins, JD, CLU, ChFC, AEP, is a principal & senior legal consultant for Mercer H&B Executive Benefits. She may be contacted at Lynne.Stebbins@mercer.com.