If your company has multiple owners, a buy-sell agreement is vital to ensure a friendly and orderly succession of the business.
“A buy-sell agreement sets the terms and conditions for the sale and purchase of shares of the business in the event of death, disability, divorce, disagreement or distress,” says Frank Fantozzi, CPA, MST, PFS, CDFA, AIF®, CEPA, president and founder of Planned Financial Services. “If you fail to implement a buy-sell agreement, the viability of your business is at risk.”
Smart Business spoke with Fantozzi about the important role a buy-sell agreement plays in alleviating uncertainty and simplifying the transition between business owners.
How can the five Ds impact a business?
Death, disability, divorce, disagreement and distress can all have a major impact, to the point of driving a company out of business. For example, what happens when an owner dies? Will the business lose sales, clients or employees? What about the management team and remaining owners? For most owners, the business is their largest asset. How will the shares be redeemed from the estate for fair value?
Disability creates uncertainty. If an owner is returning in a few months, that’s a temporary disruption. But what if that person is out for an indefinite period or is unable to return? Who will fill the void?
In a divorce, your business is generally your main asset. If the business is a marital asset and your spouse is entitled to 50 percent of the value of a $10 million company, how will you pay that $5 million? If you have terms in place, you can pay over time and prevent the spouse from being an owner. However, failure to put a system in place could bankrupt the company.
Disagreements can occur even among partners who previously worked well together. How do you resolve a situation where partners want to take the business in different directions or retire earlier than planned? Finally, distress is often the result of external threats to the business, such as regulatory changes, supply chain disruptions or the loss of key employees. How does your contingency plan work?
How does a buy-sell agreement help?
It establishes agreed-upon terms for how each of these risks will be addressed, paving the way for the business and its owners to move forward. It should be reviewed every few years to ensure it remains current. Keep in mind, banks, insurance companies and vendors that have a vested interest in the business may demand a buy-sell agreement be established to do business with your company. Without it, you may not be able to get a loan, or you may lose clients or investors who are unwilling to take on the risk of a disruption to your business.
How can you value a business and ensure a successful transition?
The simplest method is to use a financial formula, such as EBIDTA, or to look at industry averages. A preferred method is to use independent third parties to determine value by weighing factors in addition to financial formulas, such as current market conditions, internal processes, technology, social capital and how the company is managed compared to its peer group. This takes more time and is more expensive. However, as business complexity increases and revenue grows, there is more at stake, so it’s a good investment for obtaining an accurate value.
How can businesses fund an ownership change?
In the event of death or disability, insurance is one way to ensure funds are available should a payout become necessary — or you could self-insure from cash flow and set workable terms. While the business valuation will remain constant regardless of circumstances, you can set different terms and conditions for how each individual transaction will be executed. The key is having a plan to address each stated risk.
Ideally, you want to establish an agreement sooner than later, especially when owners are on good terms. It becomes more difficult when there is stress, or owners aren’t seeing eye-to-eye. A buy-sell agreement is the best method to ensure your business not only survives but thrives. That’s why it’s not a maybe, but a must, for any business. ●
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