| Buy-sell agreements a family business
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| By the way,
there is another party that will be very interested in your valuation method:
the Internal Revenue Service. The tax man has made it clear under Treasury
Regulations Subchapter B, Section 25.2701-1 and 25.2701-2
that it will watch much more closly the valuations of a buy-sell agreement if
the participants are related.
5. Buyout financing
Buyouts can place serious strain on a business's reserves and force
a closely held business into unattractive alternatives. That's why
many family businesses use life insurance to secure control of the
company on the death of an owner. Essentially, if the value of an
owner's share is estimated at $5 million, the company takes out
a $5 million policy on her that names the company as beneficiary
to fund the buyout at death.
What many buy-sell agreements fail to take into account
is the far more likely scenario that an owner will become incapacitated
for the short or long term. In these instances, a mere life insurance
policy won't be much help.
"You're in a very big Catch-22 because morally
you don't want to hurt your spouse or sibling, you all built this
together, but practically the business can't afford to keep paying
him and get a person of his skills and abilities," says Fairfax.
"So the business is going to keep going down, which of course
lowers his value, but you don't have the cash flow to buy him out.
It can get to be a very ugly picture."
Keys to buyout financing: Include disability insurance,
establish a schedule of payments over time and rather than a lump-sum
payout, agree to one-third or one-fourth down. That way, the business
won't be forced into unseemly circumstances. Also, consider discounts
to the payout amounts for such things as lack of marketability and
lack of control; after all, the company deserves some compensation
for its loss of a key owner.
Important addendums
Faulkner notes a couple important addendums that many businesses
overlook when drafting a buy-sell agreement: a noncompete clause
and a look-back provision. The noncompete clause prevents one of
your family members from taking his buyout and starting his own
business in competition with the family business. A look-back clause
protects a departing owner in the event that other family members
secretly conspired to profit from his departure.
Faulkner has seen it happen:
"One of three siblings left the business, they
abided by all the discounts, and six months later, the two other
siblings sold the business at a high value where no discounts would
have been applied. So the question came up: Was this contemplated
at the time? Was this fortuitous timing? The skeptic in me says
they probably knew of something on the horizon."
Correctly executed, a buy-sell
agreement can keep peace in the boardroom and in the family. It can even be a
powerful management tool. One of Faulkner's clients has a buy-sell that provides
that when he turns 65, 30 percent of his stock will be distributed in bonuses
to his management team, which previously had worried that the company would fall
into the hands of incompetent heirs.
The best time to establish a buy-sell agreement? While
Mom and Dad are still on the scene, or early on among the successor
siblings, says Faulkner. "Typically, if it can be implemented
at that earlier, transitional stage, it can have better outcomes,"
he says.
But remember: Don't shake hands on a buy-sell agreement
without first running it by your accountant, your attorney and your
financial adviser. There are important tax considerations that,
if addressed upfront, can be as valuable over time as the savings
from the buy-sell provisions themselves.
Jay MacDonald
is a contributing editor based in Mississippi.
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