Succession Planning Part 2: The Buy-Sell Agreement

Last time I touched upon Succession Planning, and gave you all precursory explanation about what things to consider and why it is important. Today, I am going to talk about one of the tools we use to help co-owners deal with succession matters. In particular, I will be talking about the buy-sell agreement and why it is a good tool for co-owners to consider in their agreements with each other.

Using a Buy-Sell Agreement

One of the best ways to insure that your family is taken care of your and so that your partners can rest assured that there will be minimum disruptions to the company should you become incapacitated, die, or even leave is a buy-sell agreement.  Let’s take a step back for a moment before getting into the details of a buy-sell agreement. I will use an example of  what could go wrong without a buy-sell agreement.

Example

Say there is a growing business, incorporated, with three co-owners who own equal shares. Furthermore the three owners have no buy-sell agreement and no restrictions on the shares they own. Let’s say one day, one of the co-owners of dies. This puts the remaining two owners in a very difficult position.

First of all, let’s say the dead owner has no will. His ownership interest will go to his spouse, and if there is no spouse, his heirs, and so forth. The bottom line is that the remaining co-owners must now deal with the dead co-owner’s family, whose interest in the business may not be the same as their own.

Consider that they may want to manage the company, which they are entitled to now as co-owners. They may want to sell their ownership (due to the lack of restrictions on transfer) to others to raise money, which means the co-owners would have to face having partners like a giant company that may be hostile toward their plans or people who lack the same vision.  The reality is that without a way of preventing what happens to a co-owner’s interest when they leave, die, or become incapacitated the fate of the company is unknown leaving the remaining co-owners at the mercy of whoever gets the shares.

Getting Back to Buy-Sell Agreement: Restrict Transfer of Ownership

If you have a corporation or a limited liability company, the first thing you want to do is restrict the transfer of shares or interest in the business through the bylaws or operating agreement, respectively. There are a variety of ways to do it, but for simplicity sake, let’s say you choose to give the right of first refusal to the business. This means when you leave or die, the ownership interest must be first offered up to sale to the company to buy back. The company has the right to first refuse. In this way it prevents the sale of ownership outside of the people running the business. This then becomes apart of the agreement or series of agreements to for the company to buy back the ownership from the leaving owner who is selling them. Thus there is a buy-sell.

Funding the Buy-Sell Agreement: Life Insurance

Notice so far I have only talked about preventing the transfer of interests out of the company. Where does the company get the money to buy back the selling co-owner’s interests? You don’t want to have to sell important equipment or try to take out cash from the operating account to payout on the agreement do you? No, that would disrupt the business.

One of the best ways to fund this type of agreement is the use of life insurance. What typically happens for many buy-sell agreements is that the company takes out life insurance policies on all the owners. The company owns their life insurance policies, thus in the event of death or incapacity payment is made to the policy holder, the company, which then in turns uses that money to buy the deceased owner’s shares stated in the buy-sell agreement. Thereby, avoiding the company’s need to liquidate things to pay for it, and insuring the living relatives of the co-owner get some sort of compensation for all the time and energy spent with the company.

What about Tax Planning? 

Restricted shares, life insurance, and a buy-sell agreement for founders are only a tiny part of succession planning. In fact, such planning generally dovetails nicely into one’s personal asset transfers before and after death.  Buy-sell agreements have been used for intergenerational businesses, where one co-owner decides to leave ownership to one of their heirs.

Therefore, your child (if they want) may continue on your dream business and you will know that you will lessen the burden of estate taxes on them. Specifically, this is the area of estate planning, which my 2011 Leadership Institute fellow and estate planner Scott C. Suzuki talked about at our co-presentation that I mentioned in the prior post.  The bottom line is that many of this techniques and tools require experts to help you draft and implement.

Consider your plans carefully as you try to grow your business and think about what the future may hold.

[author] [author_image timthumb=’on’]http://www.alohastartups.com/wp-content/uploads/2011/09/RyanKHew.png[/author_image] [author_info]I am a practicing attorney in Honolulu, HI helping small businesses with their transactional and compliance needs.
Contact Me Today: Web| 808.944.8400 @RKHewEsq Ryan K. Hew, Attorney At Law[/author_info] [/author]

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*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.   No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.   Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.