Buy, sell or hold?
No, not your stock, but your business.
If you have a small business with two or more owners, you have some important decisions to make. You need to have a plan in case of any one of several disastrous circumstances.
Here is just one example, from Robert Greenberg, a certified financial planner in Costa Mesa, Calif.:
"One of my clients is the widow of a partner of a very successful employee benefits firm. When her husband died of a heart attack at age 56, she expected his partner of 20 years to treat her fairly. After all, they had been best friends, raised their kids together and grew the business together. Unfortunately, after three years of agonizing litigation, she settled the case for a fraction of the real value, just so she could get on with her life."
Other events that may put your business into neutral or reverse could be triggered if your business partner:
- Gets Alzheimer's disease and his caretaker demands to cash out his ownership interest right away.
Gets divorced, his spouse ends up with an ownership interest as part of a divorce settlement and she tries to interfere with management to get even with her husband.
Wants to sell his share to a stranger, or somebody you can't stand, like his irresponsible son.
Dies or is disabled.
Declares bankruptcy and his ownership falls into the hands of creditors.
Loses a professional license or is connected to a crime.
Wants to retire.
No longer gets along with you, and you can't agree on anything.
It's tough enough to run a successful business, even without having to deal with these kinds of problems. The best way to deal with them is to have a plan that covers all the potential problems in advance.
This kind of plan is called a buy-sell agreement. It's a binding contract among you and your co-owners that controls when an owner can sell his interest, who can buy an owner's interest and what price will be paid for it.
When an owner is thinking of selling or giving away his interest, a good buy-sell agreement steps in to give the continuing owners some control over the transaction. It generally regulates who can buy the departing owner's interest and at what price, or whether his interest can be sold at all. Sometimes an agreement will give owners the right of first refusal or could even force owners to buy another owner out.
As an owner of a business, your most important decision is first to commit to creating an agreement. This is something you don't want to put off. The second most important decision is how you'll implement the agreement. There are three main methods. The differentiation between them involves who will buy the transferring owner's interest:
- The company itself -- a redemption agreement.
The continuing owners -- a cross-purchase agreement.
Combination of the two -- a hybrid agreement.
Here is a brief overview of each method:
Sometimes referred to as an entity purchase buyback. An owner agrees to sell his ownership interest back to the business at a price and according to terms designated in the contract. The business then generally cancels, retires or liquidates that person's interests. The interest of the remaining owners is increased proportionately.
Often referred to as a crisscross agreement. Each owner agrees to offer his ownership interest for sale to the other owners at the price and according to terms designated in the contract. Continuing owners can purchase a share of the departing owner's interest in proportion to their current holdings. For instance, a 10% owner will buy 10% of the departing owner's interest. This method can get very complicated when there are more than two or three owners. The number of cross agreements makes things look like a spider web.
A combination of the first two. Owners agree contractually to sell to either the business itself and/or the other owners. Of course, the circumstances, price and terms are clearly specified in the contract. This is considered the most flexible method, since the owners can wait and see what the circumstances are at the time they have to make a decision.
There are three very important issues in every agreement:
- You have to determine the proper tax basis for each person. There are capital gains and ordinary income tax consequences. You'll need a tax expert help you with this.
Every agreement has to be funded. In other words, how is an owner's interest going to get paid? There are numerous variations on this, but agreements are generally funded with cash, an installment plan and/or life and disability income insurance. In many cases a combination is used.
The value of the business has to be determined. It's generally a moving target, so a formula is often used. The
Internal Revenue Service wants a written appraisal from a recognized entity, such as an accounting or legal firm, in order to accept the tax implications of a buyout.
These are just the high points of buy-sell agreements. An attorney should draw it up. A do-it-yourself kit will probably create more problems than it solves.
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Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at