After signing your buy-sell agreement, do you believe you have solved your business continuity problems? Many of these agreements create more problems than they solve and only partially solve business continuity problems.
“The creation of buy-sell agreements involves a certain amount of future-thinking. The parties must think about what could, might, or will happen and write an agreement that will work for all sides in the event an agreement is triggered at some unknown time in the future.” — Z. Christopher Mercer, Mercer Capital
So, why is it important to update buy-sell agreements?
Gap 1: Ignores Threats to Business Continuity
Most buy-sell agreements don’t address the challenges that the business, surviving owners, and deceased owner’s family will face after an owner leaves. They only address the transfer of ownership upon an owner’s death or permanent incapacitation. For example, if the surviving owner does not have enough assets to satisfy the personal guarantees previously made by the deceased owner, the business may not be able to continue once that financing is pulled. If the deceased owner was the company’s rainmaker and no one is able to step into that role, the business may be unable to survive.
A buy-sell agreement dealing with the transfer of ownership at death or permanent incapacitation only ensures that (a) the surviving owners own all of the company and (b) the deceased owner’s estate receives some value, in cash, for the transfer of ownership. It leaves other major issues unaddressed.
Gap 2: Ignores Common Lifetime Exits
Does the agreement cover an owner’s lifetime exit? An owner’s divorce, bankruptcy, termination of employment, or retirement, along with business disputes among owners, can trigger the need to transfer ownership and are more likely to occur than the death of an owner. Most buy-sells fail to consider these conditions.
Gap 3: Neglects the Decedent’s Family
Most buy-sell agreements focus exclusively on the benefits they provide to the surviving owner rather than on providing for the needs of the decedent’s family. Even if the deceased owner’s family receives proceeds for the full value of their loved one’s business interest, that amount is rarely enough to support the family at the same level as did their loved one’s lifetime income. Maintaining financial security after an owner’s death is rarely achieved from the proceeds of a buy-sell agreement.
The financial shortfall for the deceased owner’s family is caused by the loss of 1) the continued stream of income from the business and 2) the loss of the deceased owner’s compensation. Buy-sell agreements aren’t designed to address these problems. In fact, they can cause more problems because the decedent’s income rights end after the ownership transfer. The problem that you must resolve is: If you die, what will replace your income stream for your family?
Gap 4: Isn’t Up to Task
Many buy-sell agreements are too simplistic to manage the personal complexities of the individual owners who sign them and their relationships with each other. For example, companies with multiple owners often don’t treat all owners similarly, or one owner subject to the agreement may be uninsurable. In family businesses, non-business considerations may affect the design of buy-sell agreements.
Gap 5: Canned Valuation Formula
The valuation methodology is too simplistic. While a formula may be adequate when a business first forms, it does not adjust sufficiently to account for business growth.
Gap 6: Outdated
Owners rely on buy-sell agreements to manage emotionally charged situations, and if those agreements don’t account for changes in the business, they cause huge problems for everyone involved.
Gap 7: Poorly Implemented
If insurance funding is lacking or insufficient, or information about the beneficiary and ownership of insurance is incorrect, there is no way that the agreement can serve its purpose.
Questions you should ask when reviewing or designing your buy-sell agreement:
- Have you given thought to someday leaving your business?”
- How much income do you want post-exit?
- If you died today, would the proceeds from your current buy-sell plus your existing personal assets allow you to reach your post-exit income goals?
- What do you want to happen if an owner exits, whether voluntarily or otherwise?
Buy-sell agreements, at best, provide partial solutions for surviving and deceased owners and their families. Few owners are aware that even well-drafted agreements (a) only provide a partial replacement of the deceased owner’s income stream or (b) protect the business from the loss of the personal guarantor.
Buy-sell agreements typically focus on the death of the owners and ignore the likeliest transfer event: retirement or another lifetime departure for one owner.