By Thomas J. Perrone, CLU,CIC NEW ENGLAND CONSULTING GROUP OF GUILFORD, INC.
It is an overlooked planning strategy. What happens to a sole proprietor’s business when they die? The business is a financial hub for the family. At death, the hub dries up. What will happen to the owner’s financial support for the family? What can be done to protect this fiscal impact? Along with the death of the business owner, there is the business’s assets, such as, equipment, receivable, inventory, and other business property. What happens to this property? Are the heirs in a position of receiving the top dollar for what is to be sold?
Most business owners spend years building their companies. They develop relationships with customers, employees, vendors, and suppliers. They create systems, build a reputation, and work hard to make the business successful.
For many owners, the goal is either to pass the business to their family or to sell it at a future value providing financial security for themselves.
But there is a problem:
What happens to the business if the owner suddenly dies, becomes disabled, retires, or simply can no longer run it?
Without a plan, the future of the business—and the financial security of the owner’s family—can become uncertain very quickly.
That is why a sole owner should consider a One-Way Buy-Sell Agreement, sometimes called a unilateral buy-sell agreement.
A Buy-Sell Agreement Isn’t Just for Businesses with Multiple Owners
Many people associate buy-sell agreements with businesses that have two or more owners. However, a 100% owner can also use a buy-sell agreement to establish what happens to the business when a triggering event occurs.
A sole owner can enter into a One-Way Buy-Sell Agreement with:
- Children or other family members
- A trust
- A competitor
- An employee or group of employees
- Another individual or entity interested in purchasing the business
The purpose is simple:
Create a predetermined path for transferring the business and provide liquidity to the owner’s family.
Instead of leaving the family to figure out what to do with the business after the owner’s death, the agreement establishes a framework before the crisis occurs.
What Happens If the Business Is Simply Left to the Children?
Leaving a business for one’s children may sound like an obvious solution.
But ownership does not automatically mean that the children are prepared to run the company.
Some children may have the experience and desire to operate the business. Others may not.
They may not understand the industry, have the necessary management skills, or even want the responsibility of owning the company.
And if they inherit the business and decide they want to sell it, they may be forced to sell under circumstances that are not favorable to them.
The market determines the value. Competitors may recognize that the family is inexperienced and attempt to purchase the company at a significant discount.
A properly structured buy-sell agreement can provide a much more orderly alternative.
What About Leaving the Business to a Spouse?
Similar issues can arise when the business is left to a spouse.
In many cases, the spouse’s primary concern will not be running the business. It will be replacing the income and financial security that the owner provided.
That can create tremendous pressure to sell.
A spouse who suddenly finds themselves responsible for a business they have never operated may understandably want to convert the business into cash as quickly as possible.
A One-Way Buy-Sell Agreement can establish a predetermined buyer and a method for determining the value of the business.
The agreement can be funded with life insurance or, depending on the circumstances, through the future cash flow of the business.
What If a Competitor Is the Buyer?
A competitor can be an attractive buyer because it may already understand the industry and recognize the value of the company.
More importantly, a properly structured agreement can establish the price and terms in advance.
This can help protect the owner’s family from negotiating with potential buyers at a difficult and emotional time.
What If Some Children Want the Business and Others Don’t?
This is another situation that should be addressed before it becomes a problem.
Perhaps three children inherit the business; only one wants to do it.
Or one child has spent years working in the company and understands how to run it, while the other children have little or no business experience.
The agreement and the owner’s estate plan should address these differences.
The children who want to own and operate the business may have an opportunity to purchase the interests of those who do not want to participate.
Other assets can potentially be used to equalize inheritance among children.
The critical point is to make these decisions before the family is forced to put them under pressure.
Six Questions That Should Be Answered
If children or other family members will eventually own the business, the buy-sell agreement should address some fundamental questions:
- Who will control the business?
- What happens if one owner wants to sell?
- Can an owner sell their interest to an outsider?
- Does another family member have a right to refusal?
- How will the business be valued?
- What are the terms of a future purchase or sale?
These questions may seem straightforward today.
They can become extremely complicated after the owner is gone.
What Should a One-Way Buy-Sell Agreement Address?
A well-designed agreement should go beyond simply stating who can purchase the business.
- Future Owners Should Be Bound by the Agreement
If ownership is transferred to another person, the agreement should provide a mechanism requiring subsequent owners to become subject to its provisions.
Otherwise, the original agreement may lose much of its effectiveness over time.
- Establish a Valuation Process
Business value changes over time.
Rather than waiting until a triggering event occurs and then arguing about what the business is worth, the owner can establish a valuation process in advance.
One approach is to have the business valued periodically by an independent appraiser.
For example, the agreement could provide an annual or biennial valuation.
A consistent valuation process can help establish a history of the company’s value and reduce disagreements when a transaction eventually occurs.
- Restrict Transfers to Outsiders
The agreement can establish restrictions on transferring ownership of interest to someone outside the designated group.
It can also provide remaining owners or family members with a right to first refusal.
This can help prevent an unwanted third party from suddenly becoming an owner.
- Establish the Terms of a Future Transaction
Price is only one part of a business transaction.
The agreement should also establish the terms under which a future purchase may occur.
How will the purchase be paid?
Will there be installment payments?
What happens if the business does not have enough cash?
These issues should be addressed before they become problems.
- Identify Triggering Events
Death is not the only event that can create the need for a buy-sell agreement.
Other triggering events may include:
- Retirement
- Disability
- Termination
- Voluntary departure
- Other circumstances that make continued ownership or management impractical
The agreement should clearly identify the events that activate its provisions.
- Address Funding
Having an agreement to purchase the business is one thing.
Having the money to complete the purchase is another.
The agreement should address how the purchase will be funded when a triggering event occurs.
Depending on the circumstances, funding could involve life insurance, business cash flow, financing, or other sources.
The agreement should not simply identify the buyer. It should provide a realistic mechanism for completing the transaction.
Who Should Be Concerned About a Buy-Sell Agreement?
The Business Owner
The owner has spent years building the business.
Without a plan, the future of the company can be left to chance, potentially creating confusion and disagreements among family members and other interested parties.
The Family
For many families, the business represents a sizable portion of their financial resources.
It may also represent their future source of income.
The family should know what is supposed to happen to the business and how its value will be converted into financial security.
The Owner’s Advisers
A One-Way Buy-Sell Agreement should not be viewed as a document that exists independently from the owner’s overall planning.
The owner’s attorney, CPA, insurance professional, financial adviser, and business transition or exit-planning professional may all have important roles in designing and implementing the plan.
Each adviser brings a unique perspective, and coordination among them can improve the likelihood of achieving the owner’s objectives.
The Real Reason a Sole Owner Should Have a Buy-Sell Agreement
There is one important reason for a sole owner to have a plan.
The owner knows the business better than anyone else.
The owner has developed relationships with customers, employees, vendors, suppliers, and other stakeholders that have helped make the business successful.
The owner has also developed an instinct for making the decisions necessary to keep the company moving forward.
When that owner suddenly disappears because of death, disability, or another triggering event, the business experiences a transition.
Customers may have questions.
Employees may be uncertain.
Vendors may become concerned.
Family members may not know what to do.
Potential buyers may see an opportunity to negotiate from a position of strength.
A One-Way Buy-Sell Agreement cannot eliminate every challenge associated with the loss or departure of an owner.
But it can provide something extremely valuable:
Clarity.
It can establish who will acquire the business, how the business will be valued, what the transaction terms will be, and how the owner’s family can receive the value that has been created.
For a business owner who has spent years building a valuable company, that may be one of the most important parts of the overall business transition plan.
Building a business is difficult. Protecting the value you have created should not be left to chance.
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