Estate Planning with Buy-Sell Agreements

By: Paul J. Singerman, Julie E. Firestone, and Abbie R. Pappas

Estate planning is a vital tool for business owners who wish to transition and protect their assets and business interests. When doing estate planning, business owners often expect that the persons and institutions they designate to receive their assets upon death will receive either a share of their business, or assets equivalent to the anticipated value of their business. Many business owners presume that the value passing to their designated heirs will be equal (or nearly equal) to the fair market value (i.e., the value that the business owner would realize if the entire business were sold in a negotiated arms-length transaction with an unrelated third-party buyer).

However, if a business has a Buy-Sell Agreement in place, that Agreement (rather than the marketplace) will dictate the sale price paid as a result of the business owner’s death. Therefore, when doing estate planning, business owners should review the terms of any governing Buy-Sell, Option, Operating, Partnership, Shareholder or other Agreement containing buy-sell provisions. The following are some of the terms and issues related to buy-sell provisions that should be addressed in such a review:

  • Method of Determining Sale price. There are many ways to value a business. Often, Buy-Sell Agreements provide a stipulated sale price or a formula for determining sale price, or name an individual or entity responsible for determining the sale price at the time of sale.
    • If the Buy-Sell Agreement stipulates a particular sale price, the business owners should assess whether that sale price conforms to the owners’ current expectations, and whether it is consistent with the current financials of the business.
    • If the Buy-Sell Agreement includes a formula for determining the value of the business interest, the business owners should periodically “stress test” the formula, by considering whether the economic indicators used in the formula are appropriate and readily available.
    • If the Buy-Sell Agreement directs that a named individual or entity (such as the company accountant) is responsible for determining the sale price at the time of sale, the business owners should confirm that the named individual or entity is still appropriate. The designated person/entity should be reconsidered if a relationship no longer exists, or if that person/entity no longer has the sufficient expertise or access to information needed to provide an appropriate sale price.
  • Time When Sale price is Determined or Re-evaluated. Business owners should periodically review the terms of the Buy-Sell Agreement to determine whether the sale price stated or calculated in the Agreement sufficiently reflects the ever-changing performance experience of the business. If the Buy-Sell Agreement stipulates a particular sale price, is there a time frame or process for updating that sale price, as appropriate? In particular, business owners should determine whether the frequency of re-determination is appropriate and cost-effective, considering the nature of the business relative to the sale price re-determination provision. Agreements and provisions drafted when a business was formed may no longer reflect the current value or nature of a business, particularly if it has grown dramatically, expanded its operations, or brought on additional owners. Some Buy-Sell Agreements provide for a revaluation of the sale price upon specified intervals (such as every [x] years), which may be inappropriate for a business that changes in value annually, or even throughout a given year. Because dates of death cannot be predicted, business owners should “stress test” the valuation provision across different potential dates of death to see if the valuation stays true to the owners’ expectations and objective standards of measure.
  • Funding the Sale Under a Buy-Sell Agreement. Business owners often intend to fund the optional or mandatory sale under a Buy-Sell Agreement using life insurance proceeds or loans. However, these funding methods pose certain problems that should be considered:
    • Life Insurance. Life insurance may be a particularly affordable and useful tool at the time that a business is formed and owners are young, or if a business has little cash flow or value. However, with time and growth, the increase in a business’ value may outpace the expected proceeds of a life insurance policy or the policy owner’s ability to pay the premiums (e.g., on term life policies for older insured owners).
    • Loans. A Buy-Sell Agreement may anticipate that a sale of the business interest will be funded in whole or in part using a promissory note. However, the company may have cash flow that is insufficient or too unpredictable to service the anticipated loans.
    • Existing Credit Facilities. When considering funding of a buy-out under the Buy-Sell Agreement, business owners need to understand how the terms of the company’s existing credit facilities impact the company’s ability to make the payments required under the Buy-Sell Agreement.  Loan arrangements with the company’s lender or lenders may prohibit or restrict payments to buy-out owners without the approval of the lenders.  Buy-Sell Agreements should make clear that the requirements for payments to buy-out owners are subject to any restrictions set forth in the company’s credit arrangements.

These funding problems can cause friction between surviving business owners and the intended recipients of a deceased owner’s business interest. When doing estate planning, business owners should take the opportunity to review these funding mechanisms, and to consider whether they meet the business owners’ current expectations of the value that will pass upon death, the sources of funding such transfer, and the company’s ability to meet its payment obligations.

  • Permitted Transferees. Many Buy-Sell Agreements or other organizational documents governing a business (such as Operating Agreements) also include restrictions on transfer. These restrictions can be effective to prevent dilution of ownership or unintended co-owners. However, these transfer restrictions may also have unintended negative consequences, such as prohibiting transfer of an ownership interest to a business owner’s trust. Trusts are a valuable estate planning tool for avoiding probate (which may involve a court-appointed valuation of the business interest), protecting assets from creditors, and protecting the overall privacy of the business owner and his or her designated heirs. Business owners should consider whether the terms of an existing Buy-Sell Agreement (or other corporate organizational document) allow for the transfer of an ownership interest during life or upon death to a trust, and ultimately to trust beneficiaries. The terms of both the Buy-Sell Agreement and the intended trust recipient should be carefully reviewed to avoid triggering forced sale or redemption provisions upon transfer to the trust, while still preserving such triggers upon intended events such as death or divorce.

It is critical for business owners to engage in estate planning to provide for loved ones and intended charities, while also ensuring a smooth transition of business ownership interests. If you feel that the provisions of your existing Buy-Sell Agreement need to be reviewed, or if you need to update your overall estate plan and want to work with a firm that understands how buy-sell provisions will affect your plan, please contact one of our estate planning or business attorneys at Singerman, Mills, Desberg & Kauntz Co., L.P.A. to assist you.