Family-owned or controlled businesses make up roughly 90 percent of all American businesses. Unfortunately, only a third of family-owned businesses survive the transition from the first generation of owners to the second. A buy-sell agreement can ensure a successful transition by controlling how an interest in the business can be sold.
Before drafting a buy-sell agreement, pay close attention to these eight factors:
- Family relationships among owners. Thoroughly understand any family relationships among the existing owners; they may have a big impact on succession preferences and tax implications. For instance, existing family relationships may dictate whether one or more owners will have preferential purchase rights, or whether the agreement should permit unilateral transfers to spouses or children. Family relationships also affect the applicability of special valuation rules under IRC §§2701–2704, as well as a host of other tax issues.
- Working relationships among owners. Stay alert for potential conflicts or antagonistic relationships among the owners, which often lead to unexpected departures. To minimize further conflicts, give special attention to price and payment terms when drafting the buy-sell agreement.
- Relative ownership interests. Unequal ownership interests can cause another wrinkle. Both majority and minority owners could be disadvantaged, depending on who purchases a departing owner’s interest. Determine whether the owners wish to maintain their existing ownership ratio and, if so, how they’d like to do so (e.g., having the entity purchase the interest, providing for a pro-rata purchase based on each remaining owner’s interest, or granting preferential rights to certain owners).
- Ages of owners. If one of the owners is near retirement age, consider special provisions to specifically address that owner’s withdrawal. Find out whether one of the goals is to transfer control or value to members of the next generation, which may be accomplished by granting greater purchase rights or through other estate planning devices.
- Financial condition of owners. Review the owners’ financial circumstances. If certain owners would be unable to purchase their shares of a departing owner’s interest, the agreement instead could require the entity to the purchase the interest. The agreement could also provide funding via insurance proceeds in the case of an owner’s death.
- Health and insurability of owners. An owner’s declining health may also impact how you structure future purchases. For example, if acquiring insurance on an ill owner to fund a cross-purchase obligation would exceed the means of other owners, consider placing the obligation on the entity. Similarly, the owners may want their relative purchase rights structured differently if one of the owners is likely to predecease the others.
- Importance of participation in the business. Find out if the owners would like the buy-sell agreement to privilege active owners over passive owners. This can be accomplished by granting active owners greater purchase rights and/or imposing restrictions on the ability of passive owners to transfer their interests to third parties.
- Ethical risks. Conflict of interest risks permeate virtually every aspect of representing parties to a buy-sell agreement. Consequently, it’s absolutely critical to identify your client, whether it be the entity itself or some combination of the owners, and to obtain any informed consent necessary to conduct joint representation.
For more on buy-sell agreements, including tax, corporate and partnership law, estate planning, insurance, valuation, and ethical implications, turn to CEB’s Business Buy-Sell Agreements.
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