A tremendous amount of pain and aggravation can be avoided by business owners when a well thought out buy/sell agreement is in place. A buy/sell agreement is intended to spell out the formula for compensating a partner when there is a death, disability, retirement, or the owner is voluntarily leaving the business. In most cases, the owner that is leaving the business must offer the business interest to his/her partners. Sales to outsiders would be restricted, if not prohibited.
The buy/sell agreement should include all of the related businesses, including real estate entities, reinsurance companies, etc. The purchase price should be established and calculated at the time the agreement is signed and contain provisions that will allow for a simple calculation which updates the price on an annual basis. It is not advised to state in a buy/sell agreement that the price will be the “fair market value” or will be determined by two appraisals. This kind of wording is too ambiguous and it could take years to determine a value.
For example, the dealership will be valued at the net book value of the store as determined on the annual federal income tax return or CPA financial statement plus any LIFO reserve. Additionally, you would add a factor for “blue sky,” which might be a multiple of earnings as reflected on the year-end tax returns or CPA financial statements. Real estate can be based on a current appraisal plus an inflation factor or an annual property tax assessment. Regardless, you want to reduce the real estate value by any outstanding mortgage debts. The key here is to do the calculations in the first year and have the parties agree to the calculations. The initial calculation should be included as an exhibit. When an owner is selling or leaving the business prior to retirement age, a predetermined discount should be applied to the purchase price.
Additionally, a well-crafted buy/sell agreement will typically allow for the purchase price to be paid over a period of time. This will allow the surviving owner(s) to make the payments without causing an economic hardship to the business. The surviving owners will first collect on any life and disability insurance policies in place. For example, one owner dies and the value as determined by the buy/sell agreement is $5 million, and there is $4 million of life insurance in place. The $4 million in insurance proceeds is immediately paid to the decedent’s estate and the remaining $1 million will be paid in annual installments plus interest, over ten years. If there is no insurance in place at death, then the term should be extended. In the case of a disability, the term should be longer and the payments are reduced by any disability insurance payments.
Having a well thought out buy/sell agreement will protect both the buyer and seller, as well as a decedent’s estate.
If you have any questions about this article, please contact Paul McGovern at 800-849-6022 or PMcGovern@DowneyCoCPA.com.
