We continue this series on the seven common failures of business continuity agreements with the fourth on the list: They are too simplistic to manage the relationships of the owners who sign them.
Most Buy-Sell Agreements are ticking time bombs, ready to explode at the first event that triggers an ownership transfer. This is partially due to how they are drafted: namely, what provisions they contain. Often, the problems lie in what they do not contain—the situations or events that owners and their advisors do not consider. Today, we'll describe one of those areas—one that is effectively addressed by applying Exit Planning concepts to a document that many view (and draft) as if it were an estate planning document.
If you've been reading this series, you likely sense a theme here: Business continuity planning should deal with far more events (i.e., lifetime events) than just the death of an owner. Yet, advisors tend to consider business continuity to be the province of estate planners. As a consequence, a Buy-Sell (and related agreements) may work well should a death trigger a transfer but simply fall flat when triggered by the far more common lifetime events.
If, as you read this article about some of the often overlooked ownership-transfer-related designs, you think, “Should these topics be part of every Buy-Sell discussion advisors have with business owners?” we suggest that you also ask:
- If if advisors don't address these topics with owners, who will?
- What are the possible unfavorable consequences to owners and their companies of ignoring these issues?
Advisors who may be, but likely aren't, experts in Buy-Sell design and drafting, don't need to acquire that expertise. They should, however, become conversant with the problems that arise when owners and advisors fail to think through the possible consequences of ownership transfers.
Let’s look at just one issue posed in the design of the purchase and sale requirements for the buying and selling owners: mandatory or optional provisions.
Mandatory or Optional Ownership Transfer Provisions
In the previous articles in this series, we've discussed various events that can trigger ownership transfers and the challenges that come along with Loss of Financial Capital, Loss of Personal Capital, Ignoring Most Ownership Transfer Events, and Neglecting the Decedent's Family. Now, we turn to the type of purchase or sale obligation, if any, that can be imposed on these ownership transfers.
When one owner offers to sell their ownership interest and the remaining owner(s) or the company is the buyer, there are four ways to design or structure the transfer:
- Mandatory: The seller must sell
- Optional: The seller has the option to sell ownership
Buyer (co-owner or company) provisions:
- Mandatory: The buyer must purchase the seller’s ownership
- Optional: The buyer has the option to purchase the seller’s ownership
The four structures arising out of the options above are:
- The seller must sell, and the buyer must buy.
- If seller exercises their option to sell, the owner must buy.
- The seller must offer to sell, and the buyer has the option to buy.
- The seller has the option to sell, and the buyer has the option to buy.
The mandatory requirement to buy and to sell is common when the purchase price is funded (e.g., life insurance funding for a transfer at death). In a lifetime, unfunded transfer, a mandatory purchase or sale may be unrealistic or even impossible because of inadequate cash flow.
Because lifetime transfers (as well as transfers-at-death unfunded by life or disability buy-out insurance) require buyers to pay with after-tax dollars, owners may be reluctant to adopt the “must buy” provision. Instead, they want a right of first refusal. Of course, that right does not provide departing owners with any cash unless they continue to receive distributions or salary from the business post-exit, or remaining owners exercise the purchase option. This ticking time bomb is rarely addressed because there is no easy resolution: There is no readily available funding (such as life insurance used in death transfers).
Yet, lifetime transfers are far more common than transfers triggered by an owner’s death. For that reason, we suggest advisors discuss with co-owners each possible transfer event, including death, incapacitation, termination of employment, and retirement. Use the four “structures" above to discuss how each transfer event should be designed from the perspective of mandatory or optional purchase and sale provisions. Discuss the consequences of each structure from the perspectives of both the buyer and the seller.
Advisors shouldn't be surprised to run into owners who decide that there are intractable problems with unfunded transfer events because (a) neither owner has the money to buy out the other or is willing to get financing to do so and (b) neither owner is willing to accept a long-term promissory note in payment for their ownership interest. The solution, if we may be so bold as to suggest it, is to engage each owner in Exit Planning. The purpose of Exit Planning, as contrasted with estate planning, is to design and implement a plan that enables owners to leave their businesses on their terms—when they want, for the money they need, to the person they choose.
A Buy-Sell Agreement is not an Exit Plan. It is a great opportunity to engage business owners in Exit Planning by describing the difficulties of attempting to deal with lifetime transfers in the confines of that agreement.
Ownership and the Choice of Must vs. May
The inability to fund lifetime transfers usually creates the need to include non-mandatory purchase and sale provisions, but another factor that affects Buy-Sell design is the ownership itself. Consider the following four ownership scenarios to see how each can create a different set of considerations regarding the optional or mandatory purchase or sale of an ownership interest.
- Multiple owners, none with a majority interest
- Two equal owners
- A majority owner with one or more minority owners
- A minority owner
In the first ownership scenario, imagine a company that is owned equally by three individuals. No one owner controls the company. How might that Buy-Sell Agreement structure differ from one in the second scenario: two equal owners? If the transfer event is death, it is likely that all owners, in either scenario, want a mandatory purchase and sale. If the transfer event is the retirement of an owner, owners may favor a mandatory purchase and sale where two remaining owners are buying out the third. But in a 50/50-owned company, owners may not want the financial burden of a mandatory purchase—especially if both owners are similar in age.
By this point, it may seem like there are dozens of possible designs to consider in drafting Buy-Sell transfer provisions. There are. It isn't possible to address every one of them. Fortunately, an Exit Planner's role is not to resolve all issues, but to use the discussion of a Buy-Sell Agreement with owners as a touchpoint to engage them in a deeper conversation about the choices they can make to avoid creating a ticking time bomb. As part of that discussion, advisors can describe each transfer event and ask their thoughts on what happens should that event occur.
- Must the buyer purchase the seller’s ownership?
- Does the buyer have the option to purchase the seller’s ownership interest?
- Must the seller sell?
- Does the seller have the option to sell their ownership interest?
These questions, and the follow-up questions they generate, lead owners and advisors into those deeper conversations.
Next week, we discuss another common issue with poorly considered Buy-Sell Agreements: those that rely on a cookie-cutter valuation formula.