The first months of a new business are heady times. As an owner of a partnership, you have many things to juggle -- organizational papers, contracts, and tax forms, to mention a few -- never mind the actual work to be done. The last thing you have time for is worrying about what will happen when you or another owner wants to move on, retires, divorces, or dies. Unfortunately, it's a huge mistake to ignore the fact that sooner or later your business will change owners. If you doubt this even for a minute, think about what will happen if your business partner:
- Quits to move to another city with a spouse
- Leaves to join or start a competing business
- Dies or becomes mentally or physically incapacitated
- Sells his or her share to a stranger -- or someone you know well but can't stand
If you haven't made a sound agreement to anticipate and deal with these issues before they happen, you risk having a serious personal and business problem that will need to be fought out in court or even result in the demise of your company. Heed these examples.
- You may be forced to share control of the company with an inexperienced or untrustworthy stranger who buys the interest of a departing co-owner.
- You may be forced to work with the spouse or other family member of a deceased, disabled, or divorced owner. While this might be fine, there is always the possibility that the family member is inexperienced or inappropriate.
- If you leave the company or die, you or your survivors may be stuck with a small-business interest that no outsider wants to buy and for which no insider will give you a decent price.
What Is a Buy/Sell Agreement?
It's best to set some ground rules ahead of time that owners can look to in a time of strife. That's where buy/sell agreements come in. Contrary to popular belief, a buy/sell agreement is not really about buying and selling companies. A buy/sell agreement is a binding contract between you and your co-owners that defines who can buy a departing owner's share of the business and establishes what price will be paid for that share.
Your buy/sell agreement will consist of several clauses that you and your co-owners choose -- clauses that will instruct and remind you and your co-owners how to handle a potential sale or buyback situation during a change of circumstance. That change could be a shift to an owner's personal life, such as death, divorce, or a financial problem. Or it could be the result of a business-related turn of events, such as a disagreement between co-owners. And, of course, at a time when many people demand that their work be both profitable and personally meaningful, it might occur simply because a co-owner feels like doing something else. A buy/sell agreement may act as a lifeline when there is:
- An attractive offer from an outsider to purchase an owner's interest in the company
- A divorce settlement involving an owner in which an ex-spouse stands to receive an ownership interest in the company
- The foreclosure of a debt secured by an ownership interest
- The personal bankruptcy of an owner
- The disability or death of an owner
When one of these circumstances happens, your buy/sell agreement kicks in to protect your current way of doing business. For instance, you might choose to include a clause that states, " If an owner decides to leave the company, the company shall have the right to buy that owner's interest at the price stated in the buy/sell agreement." This clause protects the remaining co-owners by eliminating the possibility that the owner who is pulling out will sell his or her share to an unsuitable new owner. You'll select such clauses to go into your buy/sell agreement depending on several factors, including whether you want to keep your company very small and private, how long you expect your business to last, and whom you expect to succeed you when you die. When you're creating a buy/sell agreement, allow plenty of time for discussions with your co-owners -- talk, argue, and speculate about future possibilities.
Setting Prices in Advance
Preparing rules to guide future situations is only part of the equation. Setting a price at which ownership interests will be transferred is one of the most important parts of a buy/sell agreement. Without establishing a price for the company in advance -- or at least a formula for setting this price -- lengthy disputes and lawsuits can arise over the value of an ownership interest. Not only are these disagreements almost sure to result in personal ill will, they may even disrupt the ongoing business to the point that the company loses its edge or even falls apart.
No doubt, it can be difficult to put a value on a small or family-owned business. You can add up the worth of property, equipment, and accounts receivable, but what about the value of your customer lists and your business's reputation? Should these get factored into the equation? And, of course, whatever number you come up with, a departing business partner might have a different idea of the company's worth. These are all questions that should be answered when you and your co-owners sit down to create a buy/sell agreement.
Likewise, a company that doesn't plan how it will pay a departing owner or his or her family can be in for trouble. Having to come up with a large, lump sum payment out of the blue can sink a company. For instance, if an owner demands that the company buy back an interest and pay for it on the spot, your company may need to borrow the cash or liquidate assets to make the payment. Fortunately, in addition to providing a way to value an ownership interest, a good buy/sell agreement can set forth the mechanics of a buyout -- including the specific payment terms and the source of the funding. It's often far better to provide in advance that a departing owner can be paid in installments over a period of years. Another alternative is to tie the buy/sell agreement to the purchase of life or disability insurance for each of the business owners -- and then use the proceeds to buy an owner out. Without a funding mechanism and a reasonable payment plan, in some cases your only other option might be to file for bankruptcy -- something you surely want to avoid.
After making choices about who can buy and sell ownership interests under what circumstances and at what price, and then putting them down on paper, your buy/sell agreement will probably sit in a file cabinet until a co-owner needs to part with an ownership interest. At that point, you and your co-owners will get together and, if you're lucky, come up with a fair way to transfer the departing owner's interest. But if any disagreements arise, you'll have to digÿ