June 19, 2013
What is the benefit of a Buy/Sell Agreement and are they worth the expense? The benefits are many as a properly drawn Buy/Sell Agreement can:
- Set an agreed value for a business for purposes of inter-owner transfers;
- Prevent strangers from becoming part of the business;
- Provide continuity when an owner leaves;
- Structure cash flow and funding for a business when an owner unexpectedly dies;
- Provide for an owner’s family;
- Establish the method of selling an ownership interest; and
- Establish the control of a business when ownership changes happen.
While there is a cost in legal fees the largest expenditure is the time and focused attention of the owners. Because creating a Buy/Sell Agreement often requires owners to think through contingencies that are uncomfortable, they are more often talked about then implemented. However, the failure to plan for the death, disability or retirement of an owner may cripple a business and cause its demise.
The death of an owner is the most commonly thought of scenario and it generally creates the most difficulties if there is no planning for the possibility. Let’s use JM Bakery as an example.
JM Bakery is structured as a corporation, which is owned by John and Mark. It employees 7 people and brings in about $1,500,000 in gross revenue. John and Mark also own the building where JM Bakery is housed as tenants in common. The building is worth about $3,000,000. John is a master baker and arrives every morning at 3:00am, with his two assistant bakers, to begin his daily baking. Mark comes in at 6:00am to open the retail portion of the bakery, which he runs in addition to administering the business. JM Bakery has 3 salespeople, a delivery driver and an assistant. They operate 6 days a week. John and Mark each take home about $180,000 per year.
Imagine that John is struck by a meteor on his way to work and dies. After the initial confusion caused by John’s death, Mark knows he needs to replace John. He does some quick searching and finds a replacement master baker for $120,000 per year.
Mark then learns that John’s estate is going to his two minor children. The guardian for John’s children is John’s recent ex-wife, Sarah. Sarah now wants to poke around the Bakery to make sure that her children aren’t being cheated and she wants to be put on the bank account. She knows that John made $230,000 last year and want to make sure that Mark continues those payments. Further, her financial advisor has told her that the JM Bakery building should be generating four times the amount of rent it is currently receiving from JM Bakery.
Mark tries to explain that the business can’t afford the $230,000 payments because it has to pay the new baker $120,000 a year in salary. Worse, if the rent from the building is increased, there won’t be enough money to pay her anything from the business, although Mark thinks that fair market rent for the building is only two times what they are paying, not four. Sarah, now says that if the Bakery won’t generate any cash flow then they should just sell the business and maybe the building too because her friend said it was probably worth $15 million.
Mark now heads to his attorney’s office to try and figure out what to do. He’s been getting to the Bakery at 3:00am to help settle in the new baker, plus trying to run the business alone and dealing with Sarah as she is constantly dropping in to check on the business and demand money.
The process of creating a Buy/Sell plan for the business would have resolved some of the problems described.
- Mark could have been given clear authority over the business and restricted Sarah’s involvement;
- The value of the jobs both Mark and John performed and the value of their ownership of the business would have been identified;
- The value of the business would have been identified;
- The value of the building would have been identified;
- Arrangements to buy out John’s interest would have been setup;
- The under market rent on the building would have been identified and resolved;
A Buy/Sell Agreement is a great planning tool and provides a serious look at the business. It also provides a way for owners to make sure their family and their business partners are treated fairly when the unexpected happens. Like so many things in life the time to plan is now, before trouble occurs.
Michael E. Garner, Esq.