Considerations for the Next Generation in a Closely Held Business

Say the longtime owner of a closely held business spent years planning her estate with counsel and her trusted advisors. Her estate plan ultimately resulted in gifting her equity interest in the business to her children, the next generation. With the new owners anticipating approximately 30 years of managing this long-established business, what should the new owners consider with respect to the future ownership of the business?

The starting point is understanding the value of the business when the new ownership took the helm. This can often be found in a gift tax return filed the year the business interest was gifted. The value derived through a formal business valuation, or the imposition of a requirement for an updated business valuation in the future (as part of a shareholders agreement or a buy-sell agreement), will help the new owners set a value for future changes in ownership if a shareholder dies, becomes disabled, or voluntarily leaves the business.¹

Buy-Sell Agreement

The most common method of determining the economic impact that ensues when a shareholder leaves a business is a buy-sell agreement. A buy-sell agreement is a contract between owners that governs the price and terms under which an individual’s ownership interest would be purchased if they die, become disabled or decide to leave the employ of the business.

A buy-sell agreement helps avoid disagreements between beneficiaries of the departing shareholder and the remaining shareholders. Without a buy-sell agreement, a surviving spouse, children, or other relatives may very well need to take legal action against the remaining owners over issues such as the value and disposition of the departing owner’s equity interest. A buy-sell agreement helps avoid many potential disagreements.

Most commonly, a buy-sell agreement provides for a cross-purchase or redemption in purchasing the shareholder’s equity interest. In a cross-purchase agreement, the remaining business owners buy the outgoing shareholder’s interest. In contrast, a redemption agreement allows the company to acquire the outgoing shareholder’s interest. Some buy-sell agreements include both types of purchases. In that case, the company or the remaining shareholders typically have the first opportunity to acquire the outgoing shareholder’s interest. If that right of first refusal is not exercised, the other party is generally obligated to purchase the outgoing shareholder’s interest.

Death of a Shareholder

When a shareholder dies, a life insurance policy is commonly used to fund the purchase of the deceased shareholder’s interest. If you’re utilizing a life insurance policy to fund your buy-sell agreement, it is important to properly identify the beneficiary of the policy proceeds. The terms of the buy-sell agreement will govern this and must be specified in the policy’s beneficiary designation.

With the life insurance policy, it is also critical to determine whether it is a term or a whole life policy. A term policy typically has lower premiums but expires at the end of the stated period. A whole life policy has higher premiums but builds up a cash value that may be used during life and typically remains in force until death. In all instances, there are many business and tax considerations to address.

The death benefit of the life insurance policy should anticipate future company growth. Therefore, the policy should include a growth factor(s) that should be reviewed periodically to ensure the value and funding targets are met. Any adjustments should be made accordingly.

Disability of a Shareholder

Another important consideration that should be addressed in the buy-sell agreement is shareholder disability. Is the disability permanent? Can the shareholder continue their work at some point? The buy-sell agreement should dictate how the company will continue to pay the disabled shareholder’s salary or buy their interest in the company if disability occurs.

The buy-sell agreement should also define what constitutes a permanent disability. If the disability is not permanent (as defined in the buy-sell agreement), it should also dictate how the disabled shareholder will perform their duties and responsibilities once the disability no longer exists. This includes consideration of the compensation the shareholder was earning before the disability, how the shareholder will be compensated (and how that compensation will be funded) during the disability period, and how the shareholder will be compensated once the disability is eliminated. In any event, the disability policy is a crucial tool to consider in planning for such occurrences.

Shareholder Voluntarily Leaves the Business

The buy-sell agreement should also address what happens if a shareholder wants to leave the employ of the business for any reason. The agreement should include terms governing the valuation and repurchase of the outgoing shareholder’s shares.

In addition to outlining the company’s purchase of the outgoing shareholder’s stake, the buy-sell agreement should include restrictive covenants prohibiting a departing shareholder from competing with the business, misappropriating its customers, or taking its employees. Essentially, the provision should prevent the outgoing shareholder from directly competing with the company for a specific period of time and a specified geographic area. The buy-sell agreement is an essential part of any contract and adds value to the existing business. Absent a covenant not to compete in the buy-sell agreement, the departing shareholder’s stake could be overvalued. The covenant not to compete has additional hidden value because it preserves the company’s future revenues and profits.

Determining the Price of a Shareholder’s Stake

The buy-sell agreement should provide guidance for determining the value of the outgoing shareholder’s interest. That can be done in one of two ways.

One method is to include a formula to determine the buyout price. The advantage of this method is that it is a quick and easy way to calculate the amount and typically has minimal expense. There are numerous disadvantages, however, that almost always outweigh the convenience and simplicity of this method. Businesses are dynamic and change with time, but a formula is stagnant. As a result, the formula method only provides an approximate value at best.

A fundamentally more sound method to value a business of a departing shareholder’s shares is to consult a competent, credentialed business valuation analyst. This method provides a real-time current value of a company or a departing shareholder’s interest.

Lastly, the buy-sell agreement should specify whether the value of a departing shareholder’s shares should be adjusted for such factors as lack of control, lack of marketability, or any other variables.

Keep in mind that, in all instances, the value of a business is dynamic and ever-changing. It should be revisited periodically to ensure the buy-sell agreement covers current conditions at the time a shareholder leaves the business.

Conclusion

A buy-sell agreement is essential to facilitate the orderly transition of ownership. Whether the shareholder leaves the business voluntarily or because of death or disability, the company and the remaining shareholders should be in a position to purchase the outgoing shareholder’s interest in an orderly way that does not affect the company’s ability to continue operating.

Proper planning is an absolute necessity to avoid conflicts, disagreements, or confusion around the buyout of the outgoing shareholder.

If you would like more information or assistance with valuing your business, on fraud prevention and evaluating your existing internal controls, please reach out to Arlen Lasinsky at [email protected].

Sources

1. “Shareholder” refers to an owner of a business. This can also mean a member in a limited liability company or a partner in a partnership.