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Buy-sell agreements a family business must

There's a saying that sums up the precarious nature of family businesses: "Shirt sleeves to shirt sleeves in three generations."

In fact, financial advisers estimate that 65 percent of family businesses fail in the first generation and more than 90 percent bite the dust in the second, leaving the third generation to roll up its shirt sleeves and start from scratch.

The reason? Human nature plays a big role. Typically, the kids, having enjoyed the fruits of Mom and Dad's success without appreciating the hard work behind it, lack the creativity, dedication and vision to carry it forward.

But failure to plan for transitional life events -- the death, disability, divorce, withdrawal or retirement of an owner -- can not only topple a business, but fracture the family as well.

There is a powerful preventative measure that can preserve a family's love and livelihood: the buy-sell agreement. In it, owners specify a course of action when a "trigger event" such as death, divorce or a withdrawing partner places a business' ownership, or even its continued existence, in jeopardy. The agreement is often included as part of the company's overarching operating agreement.

Contrary to what you might expect, a typical buy-sell agreement is designed to prevent, rather than facilitate, the sale of a business. Here, buy-sell refers instead to how an owner's shares may be sold, to whom, and at what price, upon his or her departure.

Think of it as a prenup for businesses. And, just as with marital prenuptial agreements, family partners are often skittish about drafting one. It seems cold, calculating and counterintuitive to discuss family members or spouses in a business context, much less one that includes your own demise. That's right, all the fun of a prenup and a last will and testament rolled into one!

Who needs it, right? You do, if you're in business with your family or stand to inherit property in co-ownership with your siblings.

"It's quite important," says Randy Fairfax, a fee-only financial consultant with Highland Consulting Associates in Cleveland. "Because sometimes they don't keep hugging each other."

Buy-sell agreements are as individual as snowflakes, no two quite alike. But they tend to have these features in common:

1. Statement of purpose
What is most important to you as owners? Do you want a nice income stream for retirement or will you plow profits into the company for the next generation? In all likelihood, the purpose of the business founders and the second and third generation will differ markedly. The key is to arrive at a purpose for the business that all parties can live with. Much of the rest of your buy-sell agreement will hinge on it.

2. Restrictions on ownership
Here's the delicate part. Some families choose to limit ownership or controlling stock, say, to bloodline descendents, meaning spouses are excluded.

Steve Faulkner, national managing director for JPMorgan's closely held asset management and valuation advisory services group, says that's not as cold as it sounds. It's important to distinguish between participating owners, whose function is key to the health of the business, and nonparticipating family members who merely receive a share of the profits.

Next: Succession to spouses generally hurts a family business.
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