When business owners and entrepreneurs launch their companies, they are typically focused on laying the right foundation and positioning themselves for growth, and understandably so. What often falls by the wayside are exit strategies. If the owners do not have a definite and clear idea about when they will end their involvement with the business, they risk never having/living the life they have always wanted and could have had.
All too often business owners continue working in the business until they die of a heart attack or other illness without ever having developed a plan for moving on from the business. Once owners agree that an exit strategy is essential, appropriate documents can be drafted. Without a doubt the most important document in implementing an exit strategy is a Buy/Sell Agreement.
What is a Buy/Sell Agreement?
In order to successfully exit a business a number of issues must be resolved. These issues are best addressed at the beginning of a business and not after it has been operating for a number of years. By that point, if the business has been successful it may be more difficult to discuss business valuation and control. Those who remain may have far different interests and views about the business than those who are leaving. In order to minimize conflict and considerable harm to the business, a Buy/Sell should be drafted early in the life of the business.
A well-drafted and comprehensive Buy/Sell Agreement will address the following issues:
- Selecting a method for valuation acceptable to taxing authorities;
- Determining who can acquire ownership interests and when;
- Determining an order of precedence for acquisition of ownership interests;
- Determining how to fund the purchase of ownership interests.
A well drafted agreement will also accomplish the following:
- Provide a relatively simple way to transfer ownership interests between family members and other owners;
- Provide a ready market for ownership interests which are otherwise not marketable;
- Provide for protection of business know-how and trade secrets upon transfer of ownership interests;
- Provide for non-competition by prior owners upon transfer of ownership interests.
Types of Buy/Sell Agreements
A Buy/Sell Agreement can take three forms: redemption, cross purchase, or hybrid format.
- Redemption Agreement. A redemption agreement is a contract in which the owners agree to sell their ownership interests to the business upon the occurrence of a specified event (i.e., death, retirement, disability). A redemption agreement can result in adverse tax consequences if not structured properly. The sale of an ownership interest to the business may result in the entire purchase price being taxed as a dividend rather than a capital gain without any recovery of the owner’s basis. Although dividends are currently taxed at a low rate this may change in the near future.
- Cross Purchase Agreement. In this form of Buy/Sell Agreement the other business owners agree to purchase the interest of the selling owner. The purchasing owners increase their tax basis in their existing shares by the amount of the purchase price they pay. This form of Buy/Sell is often preferred for its simplicity.
- Hybrid Agreement. A hybrid agreement provides more flexibility than a redemption or cross purchase agreement. The business is given the first right to buy the owners interest but if the business will not or cannot buy the entire interest then the other owners can purchase the remaining interest. One form of hybrid agreement is called the “wait and see” agreement. In this form no decision is made as to whether the business or the other shareholders will buy the interest until a specified event occurs. Thus, depending upon the circumstances when the owner sells, either the business or the owners may be the purchaser. Usually the business is given the first opportunity to buy the interest then the other owners can buy the remainder. If the other owners do not buy the remaining interest the business must buy the remainder.
As you can see from the above, a Buy/Sell Agreement is a very useful, if not essential, business planning document. As there are several potentially complicated issues that can arise, it is highly recommended that you utilize the services of a qualified business attorney to discuss your options.
Yee Law Group, PC, L.L.P.: Sacramento/Roseville Business Attorneys
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This article has been prepared by Yee Law Group, PC, PC for informational purposes only and does not, and is not intended to, constitute legal advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.