Eric's "Holding The Bag" Exit Plan: The Ticking Time Bombs In His Buy-Sell Agreement
Eric and his partner Joe had a very profitable 25 year run with their industrial supply company, although the past couple years had been difficult. They had just adopted some well-considered strategic innovations to the “customer channel” and “revenue stream” components of their business model which they felt were keys to sustaining their competitive advantages. Both were hoping to sell the company in 10 years or so and enjoy a comfortable retirement.
So the news that Joe’s colon cancer had come back and spread to his liver was devastating. The letter from Joe’s attorney shortly after Joe’s death demanding $5 million cash for Joe’s 50% share of the company was even more unexpected. It seems that Eric and Joe were overly optimistic when they set the formula price in the mandatory death buy-out section of their Buy-Sell Agreement when they signed it 12 years earlier. They had also failed to implement the life insurance funding.
These two ticking time bombs had just exploded. There was no way Eric or the company could cash flow the price, which Eric estimated now overstated the realistic value significantly in today’s marketplace.
Research shows there are 12 principal reasons business owner transitions, successions and exits fail. Each of these reasons impacts the company’s longevity and ongoing annual profitability as well as an owner’s transition and future exit results. This article addresses the fifth of these 12 reasons:
Reason #5. Co-Owner Issues and Disputes. You have failed to utilize a Buy-Sell Agreement and a Business Continuity Agreement to pre-decide how ownership will be bought and sold (and funded) between partners upon death, disability, divorce, disputes, and retirement and how to avoid or resolve co-owner disputes due to future disagreements.
In order to protect your ownership, it’s critical that your business partners establish, properly implement and properly update a Buy-Sell Agreement. Eric and Joe hadn’t looked at their Buy-Sell Agreement since the date they put it in the drawer 12 years ago.
Businesses, regardless of age, size or business sector, are often damaged or torn apart due to lack of a well-conceived system for avoiding and/or resolving disputes. These disputes can arise between co-owners, spouses, children and in-laws.
The potential for disputes can become even more acute upon the death or disability of a key owner. The role of a spouse or other family member may take on a new significance when the other co-owners attempt to work out issues with the spouse or family member who may not be familiar with some of the inner workings and understandings of long-term business partners.
A Buy-Sell Agreement is a contractually binding agreement amongst the co-owners of a business which addresses the times and the terms for the future purchase or sale of stock of a company, both amongst themselves or to a third party.
In a sense, this type of agreement is your own private stock market, providing certain purchase and sale terms and pricing. However, unlike a public stock exchange, you and other co-owners are not necessarily free to buy and sell stock to whomever you may please. This agreement lets you restrict co-owners from selling their shares to an outside party which the core owners do not want to share company ownership with.
A Buy-Sell Agreement is used whether the company is owned by unrelated co-owners or by family members. This enables the owners to have a pre-agreed understanding amongst themselves as to how, when and under what terms stock will be purchased and sold upon future events and conditions.
The Buy-Sell Agreement is also used when there is only one present owner. Upon the death of the sole owner, that owner’s stock would typically be distributed according to the terms of the owner’s Estate Plan. The executor or trustee charged with handling the estate or living trust of the owner does not necessarily have the authority to add stock restriction or Buy-Sell Agreement provisions before distributing the stock to family members pursuant to an Estate Plan – if those ownership restrictions were not already in place at the owner’s death. In the absence of such a Buy-Sell Agreement, after the owner’s death, the stock could be owned by multiple family members, some of whom might find themselves in disagreement as to the company operations or stock ownership going forward.
Buy-Sell Agreements are prepared based on the needs and objectives of the co-owners. The various types of provisions which should generally be included, or considered for inclusion, in a Buy-Sell Agreement are: stock transfer restrictions; mandatory or optional purchase upon an owner’s death, disability, termination of employment, or bankruptcy; purchase from an ex-spouse upon divorce; a Texas shootout (where one owner wishes to force the purchase or sale of shares with a co-owner); a drag-along option (where the majority can require the minority owners to sell in a company sale); and a tag-along option (where the minority can require the majority to include them in a company sale). A Buy-Sell Agreement must have an effective, realistic pricing mechanism and payment terms. It will normally be backed up with life insurance to help fund a death buy-out.
When Eric came in to see us his options were limited. He could look for bank or other third party financing to fund the buy-out. But that would leave him “holding the bag”, because the formula price way overstated the stock’s value. He could attempt to sell the Company, but a forced quick sale would leave him with little. He could cause a statutory dissolution, but again he would be left with little.
His last option was the one which worked. Joe’s spouse was willing to negotiate both a realistic price and pay out schedule.
Just like any other corporate agreement, the Buy-Sell Agreement can be extremely effective. This requires that it be properly prepared and implemented to begin with and be properly reviewed and updated to keep pace with changing times.
Next Newsletter – How Frank’s “Wait and See” Exit Plan undermined his family’s financial health.