Any business owner who has passed a certain number of milestones in their career will eventually come to the realization that they should consider planning for the future of their business. For example, what will happen to the business when you retire? Will the business continue after your death? Do your heirs have a desire and the ability to run the business? Should the business be sold to fund your retirement? Considering these issues is an integral part of structuring an appropriate estate plan for any business owner.
The most important first step is to start thinking about it…NOW! The second most important step is to put a plan into place that is designed to reflect the realities of your business, your family life, and the goals of the next generation.
There are a multitude of options to consider, including selling the business before you retire, putting agreements into place for the sale of the business upon your death, or making arrangements so that the business can transition upon your departure with minimal disruption in order to allow the business to continue to function and thrive after you are gone. The remainder of this article will focus on one option which calls for putting a plan in place that will result in the sale of your interest in the business upon a triggering event (such as your death or disability) to either the remaining owners of the business or to the company itself. Such a sale can be accomplished through a buy/sell agreement.
There are three main types of buy/sell agreements: the Cross Purchase Agreement, the Redemption Agreement or a hybrid of the two. All three have the advantage of creating a guaranteed “market” for your business interests upon your death.
Cross Purchase Agreement. The Cross Purchase Agreement requires the other shareholders (or other equity interest owners in the case of an entity other than a corporation) of the company to purchase your shares upon the triggering event, such as your death, from your estate. A common structure is to use life insurance proceeds, from a policy held by the other shareholders on your life, to fund the buy-out. The other shareholders are named as the beneficiaries of the insurance policy and receive the insurance death benefits upon your death. These benefit funds are then used by the remaining shareholders to purchase your shares from your estate. There can be significant tax advantages from such an arrangement, as well as the peace of mind gained from knowing that your existing business partners will both provide a legacy for your heirs and continue the business after your death. The drawbacks of this plan can include a failure of the other shareholders to reserve enough cash (in the event insurance proceeds are not used as the funding mechanism) or keep the insurance premiums paid. This option also gets more complicated the more diverse in interest and the greater numbers of shareholders involved in the business.
Redemption Agreement. This option requires the company to buy back or “redeem” your shares upon your death. It boasts a certain ease of administration given that it is the company, and not the remaining individual shareholders, that must maintain enough cash reserves and/or insurance coverage to be able to fund the buy back transaction. The redemption agreement could also be structured to allow the company to pay some portion of the redemption price upon your death and to allow the company to execute a promissory note for the remainder of the redemption amount. Such a structure could be desirable because it provides your heirs with an ongoing income stream while reducing potential cash flow problems for the business.
Hybrid Approach. This approach is exactly as it sounds. Upon your death, the company has a right of first refusal to redeem any, or all, of your shares. In the event the company elects not to exercise its right of first refusal or elects to purchase less than all of your shares, the remaining shareholders then have the right to purchase the remaining shares on a pro rata basis. This approach provides the company and remaining shareholders with flexibility to wait and analyze what makes the most sense, both from the perspective of the business and the remaining shareholders, at the time of your death.
Regardless of which type of buy/sell agreement is utilized, it is essential that the agreement include detailed provisions regarding how your interest in the business will be valued at the time of your death. Providing for a valuation method or formula will allow both your business and estate to transition and flow more seamlessly and quickly after death, as there will be an objective method for determining the value that your estate will receive for your interest in the business. All three types of agreements also have the advantage of avoiding the situation where a disinterested, uninvolved, unknowledgeable or disruptive party (whether an heir or other third party) gains control of a significant portion of the business as a result of your death. This situation has the potential to wreak havoc on the operations of any business and devalue the interest held by your heirs or estate.
Business owners should consult with their attorney and other estate planning professionals to seek advice concerning appropriate exit strategies such as a buy/sell agreement. An attorney can:
- Answer questions you have concerning the procedures and legal aspects of selling your business;
- Draft buy/sell agreements, asset purchase agreements, and other documents necessary to liquidate your business assets;
- Work with your tax advisor to ensure that the sale of your business is structured to minimize tax liabilities; and
- Assist you with the preparation of a will and/or trust to ensure that your assets are transferred in accordance with your wishes.
- Facilitate obtaining insurance coverage for various estate planning or business planning vehicles
If you would like more information regarding business succession planning for your business, please contact our Business Law Group partner, David A. Closson at [email protected].