Buy/Sell Agreements. Overview. June 2002

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1 Buy/Sell Agreements An executive brief on issues and trends affecting middle market firms. Authored by: Andrew Smith, CPA, CVA Director, Valuation Services Overview Buy/sell agreements are commonly used by closely held businesses to provide a plan for the transfer, valuation, and payment of a shareholder s interest in a business. By agreeing in advance upon a process for a smooth transfer of shares, management ensures that the change of ownership will bring minimal distraction and disruption to the business. These agreements typically specify transfer terms, share valuation, and payment consideration for the selling shareholder. While, on the other hand, a buy/sell agreement assures the remaining owners that the shares being sold will be transferred to a desired owner. A buy/sell agreement also details the payment terms to the departing shareholder, which should not be detrimental to the remaining shareholders. A sound agreement will minimize the time and expense involved in liquidating and transferring the shares. An additional benefit is that the agreements can assist all shareholders in their estate planning needs. A buy/sell agreement should not be drafted solely to protect against an unforeseen death of a shareholder, but also to create security for other events, such as: Divorce Disability Bankruptcy Retirement Termination of employment Personal liquidity needs Most attorneys strongly recommend such agreements be drafted during the business creation process. Buy/sell agreements should, of course, be periodically reviewed and modified as necessary during the growth and evolution of a business. For additional information on The McLean Group and its past transactions, visit.

2 Types of Buy/Sell Agreements There are three main types of buy/sell agreements used by closely held businesses: Entity Purchase Agreements specify that the company will buy the shares of the departing (or deceased) shareholder from the shareholder or his/her estate. Cross-Purchase Agreements specify that one or more of the other shareholders may purchase the departing shareholder s shares. Hybrid Agreements are essentially the best of both worlds. These agreements let the current shareholders wait and see what the best course of action may be, depending upon the condition of the company, financial constraints of the remaining shareholders, tax considerations, and liquidity preferences. All buy/sell agreements need to be tailored to the needs and objectives of the individual owners. They can have different provisions for disposing of an owner s share during his/her lifetime and when deceased. And they do not have to be equal to all shareholders. Agreements between limited and general partners (or minority and majority shareholders) may be different. Valuation Provisions The valuation provision of a buy/sell agreement is often the most important and significant section of the agreement. In general, there are three primary valuation methods that can be utilized in a buy/sell agreement: Professional Valuation The company may engage a valuation professional to perform a valuation if an event occurs that triggers the buy/sell agreement. A professional valuation should consider asset based, market based, and income based methods and select the most appropriate method in determining a valuation of the company. Such formal valuations can be performed annually and the most recent valuation may be used for the buy/sell agreement. For additional information on The McLean Group and its past transactions, visit. Page 2 of 5

3 Formula Approach The shareholders, with advice from their financial advisors, may define a set formula to establish value for the shares. In creating a formula, it is important to identify and focus on the primary value drivers of the company. For example, a revenue based formula that specifies the value of a company being worth 1.5 times revenues does not consider earnings and may not be applicable if the company is losing money and has a significant working capital deficit. Formula with Contingency A formula can be established to set the value of the company, but in case of a significant development in the company, such as the winning of a patent, significant revenue growth, or an acquisition, then the need for a professional valuation would be triggered. This protects the departing shareholder if a significant event occurs and the shareholders have not updated the formula in their buy/sell agreement in a timely manner. If a formula is used, it is critical to define its components. Extra details and illustrative examples are helpful. Even some of the more common terms such as: revenues, book value, cash flow, and taxes should be defined (i.e., cash or accrual revenues? state or federal tax? etc.). Also, be sure to specify which financial period the valuation will be based on (e.g., the previous fiscal year, the prior twelve months starting from the previous quarter, etc.). Problems may arise if the valuation date is the exact date of death or other significant event. It may not be feasible for some businesses to produce a set of proper financial statements in the middle of the month. Some buy/sell agreements may require the board of directors or the majority of shareholders to approve the reasonableness of the valuation. In all cases, the board and the shareholders should review the valuation of the company on a regular basis. Once a valuation is determined, the actual transaction value of the shares may be adjusted depending upon the situation. In case of death, disability, or divorce, the value of the shares to be paid may differ. For additional information on The McLean Group and its past transactions, visit. Page 3 of 5

4 For illustrative purposes, payments might be made in accordance with the following example percentages: Death = 100% Disability = 90% Divorce = 65% An effective valuation for a buy/sell agreement can also help identify the value drivers of a business and help the shareholders focus their efforts towards their common goal of maximizing the company s value. An effective business valuation should be viewed as an essential strategic planning tool. Other Provisions Buy/sell agreements are contracts and should have all of the legal characteristics that make them enforceable. The form may vary depending on the type of entity, but many of the characteristics are the same. Right of First Refusal One of the most important clauses is the right of first refusal for the remaining shareholders to purchase the given shares. This allows the remaining shareholders to have the ability to control whom their fellow shareholders may be. This right is also important to maintain an insurable interest in the buy/sell agreement. Payment Terms It is also important to set realistic payment terms. The financial health of the company should not be impaired if a shareholder s shares are to be purchased. Life insurance policies are often put in place to provide funds to purchase the shares, but if the value exceeds the life insurance policy, the option to have a long-term interest bearing note may be beneficial. If payment plans are used, be sure to detail the length of plan, how interest accrues, the nature of the collateral, penalty for late payment, etc. For additional information on The McLean Group and its past transactions, visit. Page 4 of 5

5 Life Insurance Life insurance policies are typically used to fund the purchase of a departing shareholder s shares. Insurance companies have specific instruments for buy/sell agreements that are similar to whole life insurance policies. If the agreement is an entity purchase agreement, the company s life insurance proceeds may increase the value of the company. The company then needs to carry a higher insurance policy. The resulting higher values and proceeds also have a tax effect that should be considered. Estate and Gift Taxes The IRS pays close attention to the transfer of shares at a taxpayer s death if the value of the underlying business was based upon a buy/sell agreement, especially if the purchaser of the shares is a relative of the deceased. Section 2703 of the Internal Revenue Code provides the following rules for business valuations as they relate to buy/sell agreements and a taxable estate: The agreement must be a bona fide business arrangement. It must not be merely a device to transfer the business interest to a family member for less than full and adequate consideration. The terms of the agreement must be comparable to those found in similar arrangements entered into by persons in an arm s length transaction. The income tax consequences of the proposed buy/sell agreement should be reviewed by the company s and/or shareholders tax advisor. Summary Buy/Sell agreements are critical for closely held businesses. It is important to structure them to protect the departing shareholder as well as the remaining investors. The agreement should be tailored to meet the specific needs and terms unique to the situation. The valuation provision should be carefully reviewed to ensure fairness. A sound agreement will minimize the time and expense involved in liquidating and transferring the shares. For additional information on The McLean Group and its past transactions, visit. Page 5 of 5