The Buy-Sell Agreement – the Soul of a Succession Plan

| Business Miscellaneous

By Mike Alerding     It has always amazed me how many businesses are running today without the benefit of an enforceable, reasonable and affordable buy-sell agreement. What is even more amazing is that many of these businesses are mature companies where the effects of not having a buy-sell are often more critical as the patriarchs begin to look at retirement and begin to get serious about a formal succession plan. Simply put, the soul of every good business succession plan is an effective buy-sell agreement.

A buy-sell agreement is an arrangement among owners (stockholders, members, partners, etc.) and the business entity that sets forth a roadmap for how an owner is to be treated in the event of a “triggering event,” which might include death, retirement, termination from employment or any other significant change. Running a business without a buy-sell in effect is like riding in a car without a seatbelt – it is a little uncomfortable to put it on and you won’t really need it on the vast majority of your trips, but when there is an accident, it sure comes in handy.

Although a buy-sell agreement is primarily a legal document that must be drafted by a lawyer, not just any lawyer can put together an effective buy-sell agreement. There are numerous buy-sell templates available to lawyers, either from their own experience or even from on-line sources, but the right buy-sell agreement for a business is always unique to the circumstances of the business. In order to make certain that the agreement is both comprehensive and targeted to the business, there are a number of economic and business factors that need to be considered.

What can the business afford?
The agreement must take into account that the business itself must be protected under any and all circumstances. If the business does not succeed through the ownership transition period, everyone loses, including the owners, banks, employees, customers and other important stakeholders in the business. This concept must be foremost in the minds of those who draft the agreement.

Flexibility
The stockholders of today may not be the stockholders of tomorrow, and the agreement needs to take that into account. Family members, children and employees often end up being owners over time as the business changes and as people change their personal goals. Children do grow up. The agreement needs to be flexible enough to take into account these potential changes in ownership and make provisions for the “idiot son syndrome.”

Valuation
One of the most interesting discussions I have with business owners is about the true value of their business. Most, understandably, consider the value to be higher than it may really be, because it has provided them with a very good living for so long. This “intrinsic” value is often fool’s gold. The agreement needs to take into account not only the mechanical valuation formulae, but should also consider the many discounts and few premiums that real buyers will associate with value. Management dependency; customer dependency; technology deficiencies; and product line stagnation are just a few of the discounts that real buyers will consider when valuing the business. The agreement should include either a specific formula, a process for having the owners decide among themselves without the benefit of a formula, or, in some cases, have an outside qualified appraiser value the business.

Buyout Structure
Perhaps the most glaring deficiency I have seen in buy-sell agreements is the lack of a proper payment structure for buying out an owner. There is often a perception that the company will have the money or will be able to borrow the money to pay a significant amount – or all- of the buyout, to the owner at closing. Unfortunately, this is very seldom the case. The agreement must, therefore, provide a mechanism that allows for the payments to be made in a rational way and over a period of time that protects the business from financial disaster. The rule of thumb is to set up a payment plan assuming the worst and allow for the company and the owner to change the structure if things are improved when the actual event occurs.

As you move through your succession planning, be sure to establish a good buy-sell agreement or, if you already have one in place, review it and make changes to reflect the economic and business realities of today. Not only are you doing yourself a favor, but more importantly, you are providing your spouse, children and other possible heirs deal with a roadmap that will result in the maximum value with the least amount of damage to the business.

Mike Alerding is a co-founder and Senior Director of Alerding CPA Group, an Indianapolis-based public accounting firm. Visit our website: www.alerdingcpagroup.com.

This post was written by:

Michael Alerding, CPA
Senior Director

Mike has over 40 years of experience in public accounting. He is a prior columnist for The Indianapolis Business Journal and serves on multiple boards throughout Indianapolis. He currently focuses his time on litigation support, business valuations, succession planning consulting and audit and accounting engagements.
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