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Succession Planning: Avoid Pitfalls in Buy-Sell Agreements

Buy-sell agreements are an important tool in developing any successful succession plan for a business.

They address the sale or purchase of an owner’s interest in the business should certain events occur. These events can include the death or disability of an owner, a bankruptcy or divorce involving an owner, the retirement of an owner from the business, the termination of employment of an owner or key employee, and the desire of an owner to withdraw from the business or to sell his or her interest in the business to a third party.

Often, however, buy-sell agreements fail to achieve their stated objectives of orderly succession in accordance with prearranged terms.

For example, one party to the agreement – or the estate or successor in interest of the party – simply refuses to comply with the terms of the agreement, because they view the terms as unreasonable or unfair. The parties may not be able to agree as to the meaning of the provisions of the buy-sell agreement.

Sometimes the parties conclude that the terms of the agreement are not workable.

At best, any of these failures can result in a new round of negotiations between parties.

At worst, they can lead to the commencement of litigation between parties. Time, energy and money, which otherwise should be utilized to bring about succession in the business, is consumed in redesigning the succession plan.

Often, in this situation, no succession plan can be achieved, and as a result, the business may be sold or face serious financial problems.

Unfortunately, it is unknown whether a buy-sell agreement will succeed or fail until after the occurrence of a trigger event. The business owners may find that, much to their dismay, the buy-sell agreement they thought would cover the situation fails to do so, for a variety of reasons.

A buy-sell agreement generally sets forth a formula or process for determining the value of a withdrawing owner’s interest, following the occurrence of a triggering event.

Often this valuation mechanism is unclear, inappropriate or out of date.

If the price is a fixed price, and the agreement states that the owners will update the price periodically, owners often fail to do so, with the result that the buy-sell agreement now sets a price which in no way corresponds to the current value of the business.

The agreement may provide that value is determined by appraisal, and following the occurrence of the triggering event the parties discover that appraisal costs are prohibitive, or that the appraisal process called for under the agreement is not workable.

Often, obligations set forth under a buy-sell agreement are not adequately funded. A buy-sell agreement may call for mandatory purchase of the ownership interest of a deceased or disabled owner. But the parties may have failed to purchase life insurance to fund that obligation, or have failed to keep life insurance coverage updated in accordance with valuation increases. The remaining owners may be faced with the dual problem of replacing the services of a key owner, while at the same time attempting to purchase that owner’s interest from his estate.

Owners of businesses often must guaranty the obligations of that business to lenders, vendors and suppliers. These are continuing guaranties, and without these guaranties a business may find that financing is not available. Often buy-sell agreements fail to adequately address these guaranties following the occurrence of a triggering event. For example, in addition to purchasing the interest of a deceased owner, how will the remaining owners secure the release of the deceased owner’s guaranty to the senior lender?

Buy-sell agreements often are not coordinated with the estate planning of the business owners. As part of estate planning, a business owner may transfer portions of the ownership interest to family members or to trusts. Often, the buy-sell agreement is not updated to accommodate these types of transfers.

Alternatively, these transfers may constitute violations of the buy-sell agreement, thereby nullifying key portions of the business owner’s estate plan.

Buy-sell agreements must be carefully designed to fit the facts and circumstances of the business and business owners involved. They should also be periodically reviewed. Businesses change constantly, and buy-sell agreements can quickly become outdated.

However, if the buy-sell agreement is carefully designed in the first place, and then periodically reviewed and updated, it should achieve its goal of providing a successful pre-arranged succession for the business when the trigger event occurs.