Every business with more than one owner must have a Buy-Sell Agreement (BSA). I use the word “must” not because there is a legal obligation to have a BSA but because it will help avoid innumerable headaches if an owners dies, becomes disabled, or simply wants to retire.
Here are 5 uncommon mistakes business owners often make when implementing their BSA.
- They don’t know the beneficiary of life insurance policies used to fund the payout of the BSA? The wrong beneficiary designation can result in an owner and the company paying more income and estate taxes than you have to. Also, if the beneficiary designation is not correct, the family of a deceased or disabled shareholder might not receive the insurance proceeds that were supposed to receive. Contact your life insurance agent and have him get copies of your in-force ownership and beneficiary designations. Then, take this information to you CPA and attorney and make sure it is consistent with your business and tax planning strategies.[spacer height=”20px”]
- The method to value their company on a buyout does not reflect current business realities? Many BSA valuation terms are deficient. If a formula is used (i) it might not account for change in industry dynamics or the economic environment; or (ii) the appropriateness of the formula may have changed over time. If it’s a fixed price, the business may have prospered or suffered setbacks, making the original price way off the mark. And, if you are using an appraisal method, significant differences can result if the appraisal is based on what a strategic buyer would pay; what you would report for estate tax purposes; or what the liquidation value would be. The valuation formula has to take into account the evolution of the company and the industry.[spacer height=”20px”]
- They don’t know why they have a Right of First Refusal provision in their BSA? Frankly, this is a waste of paper, time, and effort. There is usually no market for a minority ownership interest. If an owner is allowed to shop the company around, important details about the company are disclosed to strangers. All counterproductive to the strategic development of the company. A more significant issue occurs if the departing owner owns a majority of the shares, and actually finds someone who wants to buy the business, and that person is a competitor, strategic buyer or other person the other shareholders don’t want. Those who care most about any new owner are the remaining shareholders. Yet, in a right of first refusal, the departing shareholder can control the process.[spacer height=”20px”]
- They are using a shotgun provision to resolve disputes because of its apparent fairness. However, disparities in the worth of owners, unequal ownership in the company, and where some owners are also employees of the business, can result in unequal bargaining position. In many cases, these owner/employees are less wealthy and depend on their ownership for their job, are often squeezed out by wealthier owners.[spacer height=”20px”]
- They don’t consider what happens if more than one owner dies or becomes disabled (especially common in medical practices), and two or more owners have to paid out at once. As you can imagine, this can be quite expensive and cause a huge drain on cash-flow. I always strongly suggest there be limits on how much has to be paid out to any one shareholder.
Why This Matters – A BSA is often the most important document a shareholder will sign. If properly designed, it will ensure a shareholder’s family is financially stable if he/she dies or becomes disabled. It will also allow the company to continue running without financial obstacles. However, if it’s not properly designed, your family may be left without any income security or any right to a business you worked so hard to build
Now Do This – Of course my suggestion is to review your BSA. But more importantly, make sure you understand how it would apply in all the situations that you are concerned about.