The purpose of a buy-sell agreement is to ensure the orderly transfer of an ownership interest in a business to a fellow owner (or to the company itself) upon the occurrence of a triggering event such as an owner’s death, disability, retirement or withdrawal, whether voluntarily or involuntarily. In reality, however, the buy-sell agreement itself can place inordinate stress on both the remaining owner(s) and on the departing owner unless carefully tailored to meet the specific needs of the parties to the agreement.
The sources of the stress can vary from setting the purchase price, the terms of payment or the tax consequences resulting from the structure of the purchase to disputes concerning the triggering events. While many business owners believe that they will be able to work things out when the time comes, the occurrence or possible occurrence of a triggering event will inevitably force both the remaining owners and departing owner to make crucial business decisions at a time when emotions are likely running high. A well-designed buy-sell agreement can at least add a degree of financial certainty and fairness to the process that will inure to the benefit of all concerned.
An appropriate buy-sell agreement must cover a number of items, including at least the following: triggering events: setting of the purchase price; payment; tax issues; restrictions on competition by the departing owner; dispute resolution; and periodic review and possible amendment of the agreement. Each of the foregoing will be discussed in this article.
A buy-sell agreement will specify when a party has a right or obligation to repurchase the interest of a business owner. Such provisions are important in all buy-sell agreements but are crucial for professional organizations, such as a group of physicians, due to licensing requirements restricting ownership of the business to individuals holding a professional license.
Typically, triggering events include:
Termination of employment
Withdrawal from group
Loss of professional license
Sale or attempted sale of the ownership interest to a third party
In the case of many professional licensees, repurchase is required by law in the event of death or loss of a license. Similarly, bankruptcy or divorce may be a triggering event where the licensee’s ownership interest is transferred to an unlicensed individual.
An area of contention may be the disability of a departing owner. In order to prevent disputes, the issue of the disability of the departing owner should be decided by an independent physician selected by the remaining owners. Further, disability should be carefully defined and limited to those situations where the departing member cannot competently perform his normal duties for the company for a specified number of hours or days (consecutive or non-consecutive) during a specified time period.
Setting the Purchase Price
There are a number of methods that can be used to set the purchase price such as a formula (e.g., book value, earnings or a combination of both), payment of the amount the departing owner paid to join the company, paying the amount in the departing owner’s capital account, setting an amount each year for buy-outs that occur the following year, or by appraisal by a qualified independent third party.
Normally, we recommend setting the amount of the buy-out by appraisal in that it likely reflects the then current value of the ownership interest. It is also probably the fairest means of setting the price in that it takes into account matters not anticipated when signing the agreement. The primary downsides to using an appraisal are that it can be expensive, takes time to prepare and may not reflect the value anticipated by the parties. If the appraisal method is used, the agreement should specify whether the business’s goodwill will be included and how the appraiser will be selected and paid.
Formulas or an agreed value price also may not reflect the fair value of the ownership interest and, importantly, invite tactical maneuvers to artificially increase or decrease the value, which can lead to unpleasant emotional reactions and litigation. If a formula method is used, the agreement should state whether all assets and liabilities be included in the computation. Normally, accounts receivables are not included in the buy-out of a professional’s interest in that they are paid out pursuant to an employment agreement.
Similarly, using an agreed value is fraught with problems. Owners may simply be too busy to consider the value of the business or may have unreasonable expectations. This is compounded by the requirement that all of the owners must agree to the value—a daunting task in itself!
Other considerations may come into play in setting the purchase price for the buy-out. For example, the payments for the purchase will be paid by the remaining owners. The fewer owners, the greater the individual burden unless, in the event of death or disability, insurance proceeds are used to make the payments.
Frequently, senior members of the company insist that younger owners fund a high buyout payment. This can be disruptive of the business and can cause some junior owners to leave. High buyouts can also give older owners an incentive to leave and “cash-out.”
It is more common in recent years for the purchase price to be limited. That is, the purchase price will include the value of the furniture, fixtures and equipment plus the departing owner’s share of accounts receivable, less specified accounts payable and liability. For a professional law or medical practice, payment of goodwill is less common since the departing owner normally takes his or her goodwill.
Paying the Purchase Price
There are several methods for funding the purchase price. These include advance funding in the form of insurance or business reserves, future funding (installment payments), or a combination of both methods.
If the amount of payout is relatively small or paid by insurance proceeds, normally a lump sum payment is made. If the firm or its members do not have sufficient cash, they could consider obtaining a business loan, albeit some lending institutions are reluctant to make this type of loan.
In the case of a high purchase price, it is usual for a down payment to be made (e.g., 20% to 25%) with the balance paid over time with interest. Capping yearly installment payments (but not the total buy-out payment) at a percentage of the business’s total revenue reduces the risk that the buy-out payments will unduly burden the company. In addition, the interest rate should be set at a level sufficient to prevent the IRS from imputing interest for tax purposes.
With regard to installment payments, the selling shareholder can have a security interest in the shares sold or in other assets. Further, the company could be prevented from using its cash for any unusual purpose until full payment is made to the departing owner. Generally, the agreement should provide for acceleration of the debt if the company is dissolved, merged, sold or files for bankruptcy.
Assuming that the company that is acquiring the departing owner’s interest is a corporation, it cannot deduct money paid to repurchase a departing owner’s stock. The departing owner, however, may be taxed on his gain at the lower capital gains rate. For a personal services business, if a portion of the money being paid is for the departing owner’s share of accounts receivable, the parties should consider whether it would be more appropriate for this to be paid under the employee’s employment contract or as deferred compensation, which may be taxed as ordinary income to the departing business owner but in later tax years.
Restrictions on the Right to Compete
There are several ways to restrict the right of a departing owner from competing. These include (1) inclusion of a non-compete agreement restricting the right to engage in a competing business within a certain number of miles for a specified period of time; (2) restrictions on the use of confidential information (trade secrets); and (3) restrictions on soliciting the company’s clients, referral sources or employees. Except with respect to the permanent restriction on the use of confidential information, these restrictions are normally effective for two to seven years. Importantly, restrictions on the right to compete may not be enforceable at all unless the purchase price includes the goodwill value of the departing owner’s interest in the company.
Amendments to Agreement
It is always a good idea to periodically review your buy-sell agreement to make sure that it reflects the realities of the business and economic circumstances. A review may also be warranted to amend the document to reflect oral agreements or other informal agreements made among the parties subsequent to the execution of the original document.
A frequent source of litigation is a change made to the buy-sell agreement with the knowledge that one of the owners will be departing shortly. It should always be kept in mind that the owners of the company owe a fiduciary duty to one another. That is, the co-owners of the business owe each other a duty of utmost good faith and fair dealing. Failure to comply with this duty can result in an award of punitive damages against the remaining owners.
Even with the most well-crafted buy-sell agreement, disputes will occasionally arise as to the interpretation or meaning of a particular provision or whether the conduct of one of the parties is consistent with his or her obligations to the company. Resolution of such disputes can be both costly and time consuming, particularly if litigation is the recourse chosen for resolution.
Buy-sell agreements usually include modern dispute resolution procedures. Typically, the agreement will provide for non-binding mediation of the disputed matter; the parties each present their case to a neutral mediator who will attempt to facilitate an agreement resolving the dispute. As a fallback, if mediation does not resolve the problem, is binding arbitration. Arbitrations are typically conducted by third party organizations such as the American Arbitration Association or JAMS, which have panels of experts (frequently, retired judges) that will issue binding decisions.
The conduct of your business has many potential pitfalls. A well-drafted buy-sell agreement need not be one of them. It can eliminate many of the uncertainties of your relationship with co-owners and enhance harmony among them; and that certainly should be your goal when deciding on the provisions being included the agreement.
FOR SALE BY OWNER—AVOIDING THE INHERENT PERILS
July 3, 2015
YOUR CALIFORNIA PROFESSIONAL LICENSE APPLICATION WAS DENIED—
WHAT DO YOU DO NOW?