Buy-sell agreements smooth family business transitions

May 3, 2011 By    

Most family business owners expect their thriving enterprises to transfer to the younger generation with minimal fuss and bother. Reality, though, can be far different. Absent a carefully designed plan, misunderstandings and disputes can turn any business transition into a costly train wreck.

Parents must analyze the skills and proclivities of their children before assigning future management roles. While such assessments can help smooth the transition, even the best of such plans needs the support of legal documents that ensure power flows to the right people and sufficient cash is available to make everything happen on cue.

Setting terms
Often the most important transition document is the so-called “buy-sell agreement,” which specifies how ownership will be allocated and how the sale of shares will be funded.

“A buy-sell agreement is crucial to a smooth ownership transition for a family business,” says Gregory Herman-Giddens, a board certified specialist in estate planning at the law firm of TrustCounsel in Chapel Hill, N.C. “It allows for one or more of the children who are active in the business to buy out a parent who retires or dies.”

Buy-sell agreements typically cover an array of issues that go beyond the basic transfer of ownership upon the death or retirement of the original owners. They also typically cover how ownership will transfer when one of the children exits the business, either through death, disability or even a decision to go into another line of work. Will the business itself, as an independent entity, buy up the shares of the departing individual? Or will the remaining siblings as individuals have the right to buy up the shares?

Here are some other issues that buy-sell agreements often cover: What if one of the siblings desires to sell shares to an outside third party? Must the siblings be offered the shares first? How much time do they have to reach a decision? And what if a child wishes to withdraw capital from the business? How much money can one individual owner take out, over what period of time, and how much prior notice must be given to the other owners?

These agreements also often specify the methods by which internal disputes are resolved. Some issues will lend themselves to arbitration or third-party mediation. For those which can be resolved by voting, the agreement will specify who has the power to vote and whether a simple majority or super majority is called for.

Buy-sell agreements can be real lifesavers in sticky situations. For example, they can obviate unexpected shifts in power to unqualified individuals.

“Often one member of the second generation receives share of ownership, then gets divorced,” notes John J. Scroggin, a partner at the estate planning law firm of Scroggin & Company in Roswell, Ga. “That individual’s former spouse now owns the equity. Unreasonable demands can follow, and that can be a thorn in the side of the family.”

The solution, Scroggin says, is to draw up clauses in buy-sell agreements that anticipate common and costly events such as divorce or unexpected death. To do this, the document should mandate a “call right” on shares that are gifted to children. The “call right” is a provision that empowers remaining family members to buy out the shares of a non-family spouse who might survive the divorce or death of a family member who was in an ownership position.

Pricing the business
The buy-sell agreement will usually specify the method for determining the business’ value upon the death or departure of an owner.

“Commonly the plan may call for a valuation to be done by a business valuation expert or CPA,” Herman-Giddens says. “There may also be a tiebreaker provision: Survivors who disagree over the business’ value might be able to choose their own expert, and then either those two experts agree on a third expert or the two values are averaged.”

An alternative valuation system specifies a formula to be used, such as a multiple of earnings. This can be problematic, though, since economic conditions at the time of a partner’s retirement or death might differ substantially from those at the time the plan is put together, making a pre-set formula inappropriate.

Avoiding problems
Successful buy-sell agreements include provisions that anticipate and obviate common problems.

Here are some tips from Scroggin, who has studied the hidden pitfalls of family business transitions:

■ Non-compete agreements
Suppose one family member desires to exit the business but desires some compensation in return. The buy-sell agreement might include a clause that specifies the value the individual will be paid for his or her shares. That sounds fine on the surface, but it can backfire if the individual then goes out and starts a business pursuing the same customers.

“If an individual is paid a lot of money for their share of the business, but nothing stops the person from competing for the very business that was purchased, why should the amount paid be any more than the value of the hard assets?” Scroggin poses.

The way to avoid this pitfall, Scroggin says, is to include a “non-compete provision” that prohibits the departing family member from engaging in a similar business for a set period of time. The agreement can also specify that the departing owner may not solicit the organization’s current customers or vendors, or utilize any of its trade secrets.

■ Tax implications
“Never provide for a business transition without having a tax expert review the documents and the plan,” Scroggin says. “Proper planning can substantially reduce the tax cost of the transaction.” In many cases, for example, the sale of the business to family members can create substantially more taxes than a gift.

■ Funding
It’s important to set up vehicles for funding the buyout. Life insurance often provides funds for buying the shares of an owner who has died. And if the owner is retiring, there can be provisions for installment payments over time.

■ Exit strategy
Suppose one child wants to leave the business after some time passes. How much will that individual be paid for his or her shares? This should be spelled out in a legal document that you can think of as a kind of pre-nuptial for business owners.

“Two people who own a business together are even more likely to divorce than a husband or wife,” Scroggin says. “There should be an agreement that defines their relationship and obligations and describes how they can exit the relationship.”

Protecting funds
Suppose your business has accumulated a large amount of money over and beyond the amount required to fund operations in future years. How can these funds be transferred to the member of the next generation?

The answer often poses a puzzle: On the one hand, you want to make sure the funds stay in the family. On the other hand, you do not want to give so much money to individuals – particularly very young ones – that they will lack incentives to do anything productive with their lives.

In many cases, the answer to the puzzle is to establish what is called an incentive trust. This vehicle provides for the incremental transfer of funds to the next generation, but only when those individuals have reached specified parameters, such as finishing their education.

“Incentive trusts are perfect for liquid assets,” says Wayne Rivers, president of the Family Business Institute.

They can be written so that rewards are given for performance in or outside of business. And the reward formulas can be flexible.

&ld
quo;Suppose one child decides not to remain in the business,” Rivers poses. “The trust can be written so that it rewards the individual who goes into a public service to be a public defender, a missionary or similar work.”

The trust might pay 40 cents for every dollar earned in such pursuits. Any number of such parameters can be written into the trust document.

Starting early
Before legal documents are drawn up, the proclivities and skills of new generation members must be assessed. The process should start with individual interviews, assessing the goals of each family member. Then goals should be incorporated into documents that ensure the smooth process of business and wealth transfer.

Many family business owners hesitate to draw up transition plans because of the current uncertainty in tax laws. Such hesitation is not necessary, Herman-Giddens says.

“A qualified attorney can create a flexible plan that anticipates many different tax scenarios,” he adds. “So put a plan in place now and have some peace of mind that you and your family are protected. You can always update your plan in a year or two.”

Indeed, delay can be costly. “Don’t wait until one of the owners is sick or gets ready to retire,” Herman-Giddens says. “There can be an unexpected incapacity or death at any time.”

Learn more about buy-sell agreements
You want to learn as much as you can about buy-sell agreements, which are detailed plans that attempt to ensure the smooth transfer of businesses from one generation of owners to another. Here are some useful resources:

■ The Small Business Administration (SBA) has published a comprehensive document on family business transition. Go to www.sba.gov and search for “Family Business,” then for “Transferring Management in the Family-Owned Business.”

■ Northeastern University’s Center for Family Business maintains a compendium of articles at www.fambiz.com. Click on the “Search” button and enter “Buy-Sell Agreements.”

■ “Avoiding Mistakes in Buy-Sell Agreements,” by John J. Scroggin. This white paper is available from the law firm of Scroggin & Company in Roswell, Ga. Visit www.scrogginlaw.com.

Photo above courtesy of iStockphoto.com/Steve Debenport

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