Transferring your legacy

Don't go into business with the attorney of your deceased partner's spouse

7 Minute Read

Advice to business owners: Understand how—and why—to properly structure and fund a buy/sell agreement

The story of a lifelong friendship turned into a successful business partnership should have a happy ending. But due to a sad, although not uncommon, sequence of events that could have been avoided with some forward planning, here’s one that doesn’t.

Sam and his business partner, Michael, both in their mid-40s, built their auto parts manufacturing business from the ground up after graduating from college. Apart from the usual bumps in the road as they got their start, they were ultimately very successful and the business now employed 105 people and produced more than $35 million in annual sales.

Then the unthinkable happens. Michael, an avid runner, had a major heart attack, while out for a five-mile run, and died.

 

Reality sets in on all fronts

Overnight, the company had not only lost its best salesperson, but it’s marketing guru and emotional leader as well. Sam’s role as operations and finance chief meant he had little involvement in the company’s marketing and sales efforts.

It was Michael who had negotiated most of the company’s biggest contracts with the major auto companies and losing him could put some of the company’s future contracts at risk. In addition, the company had recently borrowed $11 million to purchase new machinery essential to winning another contract with its biggest customer. Michael had been negotiating an extension of that contract when he died.

Additionally, Michael’s homemaker wife, Jenny and their three young boys needed to be cared for. And like many entrepreneurs, 90% of their wealth was attached to the business. They did have modest personal savings and some retirement plan assets, but these assets would provide only 10% of the income the family would need to maintain their lifestyle. Because they were young and healthy, they had deferred the decision to purchase any life insurance. The ownership of 50% of the company, and the income it provided, was almost everything they had.

 

Sam's four options

In addition to continuing operation of the business, Sam considered four other options: 1) sell the business to Jenny; 2) buy the ownership interest from Jenny; 3) find an investor to buy out Jenny’s interest; or 4) sell the business outright. For various reasons, none of these options made sense, so Sam decided to continue operating the business and Jenny agreed—with the understanding that a lot of changes needed to be implemented.

 

The thin line between friendship and finances

Despite the anguish over losing his best friend, Sam had to keep the business running. He immediately needed to hire a full-time salesperson to assume Michael’s role and absorb the continued cost of paying 50% of the dividend income to Jenny, as she was now a 50% shareholder of the company.

Over the next few months, revenue fell below expenses, largely due to the loss of the contract Michael had been negotiating, and the bank that had financed the new equipment needed to fulfill that contract. However, concerned about the company’s ability to repay, it began to seek more restrictive terms. This added up to negative cash flow, and Sam needed to cut annual distributions which impacted Jenny.

Totally reliant on the steady income the business had provided for years, even through tough times, Jenny took Sam’s action personally. A few weeks later, Sam received notice from Jenny’s attorney that she was suing the company for 50% of its last appraised value of $25 million dollars.

 

Protection of a buy/sell agreement

Had Michael and Sam developed an effective buy/sell agreement upfront, they could have protected the surviving partner and their families by establishing the terms and timing of a sale arrangement at a pre-determined price in the event of the death of either owner.

There are multiple ways to structure and fund a buy/sell agreement. Each of them has advantages and disadvantages in tax planning, asset protection, and cost and ease of management, and each depends on ownership type and personal preferences.

Here are a few things to consider:

1. Regularly Update Your Valuation 

Buy/sell agreements are often created when a company is young. As such, it is common to see agreements with a sale price well below the actual value of the company. Updating your valuation every two to five years can prevent unintentional mispricing and potential litigation from heirs.

 

2. Be Certain Your Terms of Sale Are Clear and Appropriate 

Most buy/sell agreements fall into one of two categories: a mandatory sale or transfer of interest, which assures that control stays with the surviving owner by stipulating that the heirs sell their ownership interest and the surviving owner(s) buys it; or a put agreement which allows the ownership interest to be either retained or sold by the heirs.

 

3. Adequately Fund the Agreement 

Even more common than failing to draft a buy/sell agreement is the failure to adequately fund the terms of the agreement.

 

Four basic ways to fund a buy/sell agreement:

  • Set up a sinking fund and pay into it over time. This requires the business to set aside high levels of cash every year.
  • Borrow the money at death. Although possible in some cases, unless the company has superior cash flow, most financial institutions hesitate to lend to a company where one of its owners has recently died.
  • Make installment payments to the heirs. This assumes that cash flow is sufficient enough to support it.
  • Life insurance. In most cases, this may be the most logical option because the proceeds are delivered at the precise moment they are needed—and they are provided income tax free. In addition, the cost can be minimal compared to other methods.

No matter how you ultimately decide to fund your buy/sell agreement, it’s important to keep in mind that for every day the value of your business increases, without a plan for future transition your financial risk increases right in step.

 

Steve Sherline, Managing Director, Private Wealth Management

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Wealth planning strategies have legal, tax, accounting and other implications. Prior to implementing any wealth planning strategy, clients should consult their legal, tax, accounting and other advisers.

This material is intended solely for informational and educational purposes, and is not intended for use as the basis for legal or tax advice or to be considered an opinion and does not contain a full description of all facts or a complete exposition and analysis of all relevant circumstances.