Due to many factors, such as aging business owners, the Coronavirus Pandemic, and the “Great Resignation,” many business owners have begun to consider or are actively pursuing an exit from their business. According to the Small Business Administration (SBA), it is estimated that there are over thirty-one million privately-owned businesses in the United States. In a January 2022 article in Forbes, it was estimated that 40% of small businesses or franchises are owned by Baby Boomers and 10,000 of those are retiring each day. Another factor that should not be overlooked when thinking about transitioning out of your business is the current and future markets. Many private equity and venture capital firms have excess cash on hand that they need to deploy on behalf of their investors. These market conditions have given rise to higher-than-average multiples and purchase prices, which ultimately benefit the seller. As inflation continues to rise and market conditions change, this favorable market may change as well.
A business exit can take many forms such as a sale to family members, sale to the current management team, turn over day-to-day operations to management team, sale to private equity or venture capital, or create an employee-stock-ownership plan (ESOP). These exit strategies can take significant time to accomplish and, if not handled correctly, can negatively impact both the current operations and future success of the business that owner(s) have worked tirelessly to build. Many believe that the final test of a great business owner is the ability to successfully pass their business on to the next generation or next group of future owners.
Over the next few months, we will be releasing a series of articles discussing important topics related to the succession of ownership and management of closely held businesses. The goal of these articles is to provide important information to help you understand the various aspects of business succession and potential pitfalls that need to be considered as owners consider this important next step in the life cycle of their business, and ultimately their personal life.
We believe these articles will be informative and help both the company and its owners navigate this process and understand the nuances involved in transitioning management of a business or selling it to a new ownership group.
Our first topic is the Importance of Buy/Sell Agreements
A buy-sell agreement (also known as a buyout agreement or shareholder agreements) is a legally binding contract between business partners that stipulates how ownership and management of a business will continue after certain triggering events occur. The most common events covered under a buy-sell agreement are when one or more owners quit, are fired, die, or retire (or QFDR for short). Divorce is another common triggering event that can be included in the agreement when applicable.
One way to understand the importance of an effective buy-sell agreement is to imagine yourself in a hypothetical scenario in which you or your fellow business owners experience a QFDR event. Chances are that you and the other owners are now in a period of considerable distress due to the QFDR event and may find yourselves on opposite sides of a major transaction. Without clear direction in place, disputes may arise among business owners and/or their surviving spouses that can potentially drain valuable time, resources, and create costly litigation. These events can also force the owners to shift focus from operating their business while they deal with these issues, which could lead to the loss of customers, contracts, or key employees.
Some of the most important questions that should be addressed in an effective agreement are:
- Under what circumstances can a business or other owners purchase the shares of an existing owner?
- To whom may the surviving owners sell that interest?
- Do the surviving partners have the right of first refusal in the sale of an interest by an existing owner or their estate?
- How much is their interest worth and how is it valued?
- How will a potential buyout be financed or what are the payment terms on this type of transaction?
Each of these questions has additional complexities that must be considered and addressed. For example, a life insurance policy is a commonly used mechanism for a business to be able to buy out the ownership of a deceased owner so that additional debt financing is not needed to provide liquidity to their estate. The valuation of each owner’s interest is another point that deserves extra attention and must be addressed in these agreements. Will the owner’s interest be valued using a formulaic approach based on agreed-upon financial metrics or is a business valuation performed by an unrelated third party required? The agreement may stipulate the third party will review the formulaic calculation, perform the valuation if it is required, or require all parties to agree upon the third party to use.
Due to the ever-changing environment and state of businesses, it is recommended to revisit, and if needed, revise a company’s buy-sell agreement periodically. This helps to ensure that the agreement remains relevant for the company and its owners. A buy-sell agreement that was first signed when a company was formed may not be appropriate or effective several years down the road. Periodically reviewing these agreements will help ensure that the agreement is written to protect the future of the company and the owners.
Another common situation to implement a buy-sell agreement is when a parent starts a business and over time transitions ownership to their children, some of whom work in the business and some of whom do not. These agreements can allow for the child or children that are active in the business to buy out their siblings who are not active in the business. As noted above, these agreements determine how the ownership interest is valued and the terms for buying back the ownership interests. These agreements help to simplify the process and reduce conflicts among the owners/siblings if a buy-out is needed.
At Elliott Davis, our closely held business and forensic, litigation, and valuation practices have experience working with customers to implement buy-sell agreements that are tailored to their unique situations. We also assist with periodic reviews of these agreements to ensure the right fit for the future of the company and its owners. When properly maintained, a buy-sell agreement is an excellent and low-cost way of reducing inherent risks that every company faces.
We Can Help
We hope you’ve enjoyed this valuable information, please be on the look out for more in our series on succession and transition planning. This series will also include the following topics:
- Coordinating business succession and estate planning
- Who could I sell or transition my business to?
- The appropriate structure for selling a business
- Business succession traps to look out for
- Ways to attract and retain key members to help manage your business
If your business is in need of a buy/sell agreement, or any succession and transition planning service, please reach out to one of our closely held business experts
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.