Buy-Sell Agreements

ow do you decide which type of buy-sell agreement is best for you, your family, your business stakeholders, and your business entity? Which factors are important to consider when formulating a buy-sell agreement with tax and legal counsel? We’ll cover the answers to these questions in the following pages as well as discuss the types of transfers and restrictions that are used in crafting buy-sell agreements.

As mentioned in earlier chapters, there are three types of buy-sell agreements: cross-purchase, redemption, and hybrid. The following section outlines some of the most important considerations in making your decision about which type of buy-sell agreement is best for you.

Number of Owners

As a general rule, the greater the number of owners, the more likely it is that the buy-sell agreement will be of the redemption variety, because cross-purchase buy-sell agreements generally become unwieldy and impractical when there are more than three or four owners. That’s not to say that you can’t have a cross-purchase buy-sell agreement with a large number of owners, but it’s just not as common.

Nature and Size of the Entity

The financial size of the entity can have a significant impact on the type of buy-sell agreement that is best to use. Generally, a buy-sell agreement for an operating company where the owners also work part time or full time will be different from that of an entity where income is earned passively. As a general rule, a larger company will call for a redemption buy-sell agreement or a hybrid buy-sell agreement because the ownership interests will probably be worth more. Additionally, the type or nature of entity—corporation, LLC, or partnership—can influence the selection of the buy-sell agreement due, in part, to tax reasons.

Value of the Entity

Generally, the higher the value of the entity, the greater the likelihood that the buy-sell agreement will be a redemption buy-sell agreement or a hybrid buy-sell agreement. This is because the entity is most likely generating income and cash flow that could be used to fund a buyout. This approach will probably be necessary because the interests will be expensive, due to the entity’s high value. When there is a disparity between the fair market value and the book value of an entity, this disparity impacts not only the type of buy-sell agreement required but how the entity interests are valued for purposes of the agreement. Under these circumstances, the likelihood of valuation by appraisal is higher.

Relative Ownership Interests

The larger the ownership interest of a business entity, the greater the likelihood that the buy-sell agreement will be a redemption or hybrid buy-sell agreement—all other things being equal. This is because value generally follows the size of the interest. A bigger interest is worth more than a smaller interest, and the more an entity interest costs, the greater the likelihood of a redemption or hybrid buy-sell agreement, because the entity usually has the most money and wherewithal to buy an interest.

Relative Ages of the Owners

When there is a disparity in age between the owners of an entity, there is a greater likelihood of a redemption or hybrid buy-sell agreement, because the senior generation usually owns more interests. This ends up costing the younger owner, often necessitating the entity’s cash flow to assist in the buyout.

Financial Condition of the Owners

Generally, the shakier or more questionable an owner’s finances, the more likely a redemption buy-sell agreement is necessary, because the entity usually has more money. This is because in a cross-purchase buy-sell agreement, the owner with the shakier finances may be unable to pay the purchase price for an interest he or she is obligated to purchase under the terms of the agreement. This, in turn, could undermine the other owners’ original expectations for the buy-sell agreement, leading to potentially bad news for the owners relying on the owner with the shakier finances to purchase their interests.

Enforcement of Buy-Sell Agreement Concerns

The greater the owners’ concern about one of them reneging on the purchase or other terms of the buy-sell agreement, the more unlikely the chances for a redemption buy-sell agreement or a trusteed/escrowed cross-purchase buy-sell agreement.

Desire for a New Basis for the Purchasing Owner

If the purchasing owners want a new basis in their ownership interests, this favors the cross-purchase buy-sell agreement, because the purchasing owners will get a cost basis in the acquired interests that is equal to the purchase price. This is not true in the redemption buy-sell agreements because the entity is the buyer of the interests.

Health and Insurability of the Owners

When one owner has low life insurance liability due to good health and another is uninsurable due to poor health, a redemption buy-sell agreement is often preferable, in order to handle the disparity in insurance and health payment obligations between the owners. This tends to adversely affect the other owners, who are often younger, in better health, and without as much in the way of financial resources because they are bearing the cost of the older owner’s insurance.

Commitment of Owners to the Business

If some of the owners are not committed to long-term participation in the business, consider either a cross-purchase or a hybrid buy-sell agreement. These agreements can allow the interests of the uncommitted owner to be purchased directly by an owner who is interested in staying long-term.

Availability of Assets inside of the Entity for Redeeming the Interest

The availability of an entity’s assets often dictates the form of the buy-sell agreement. Some types of businesses—for example, general construction contractors—have minimum asset and performance bond insurance requirements that may give rise to the use of a cross-purchase agreement if the arrangement cannot be covered with life insurance. This is because using entity assets to buy out an owner could cause a default under a performance bond or reduce the size of jobs the entity may bid on going forward.

State Law with Respect to Entity Redemptions

In the case of a corporation or of distributions to members of an LLC or partnership, especially if the entity is lightly capitalized (e.g., a service business), consider a cross-purchase buy-sell agreement or hybrid buy-sell agreement, because the entity may not have enough legal or stated capital to do a redemption.

Existence of Restrictions under Loan Agreements on the Use of the Entity’s Assets to Redeem Equity Interests

The existence of onerous terms under entity loan agreements may make stock redemptions difficult because lenders often will not consent to use of their collateral to buy out an owner. This would militate in favor of a cross-purchase buy-sell agreement.

Family Relationships among Owners

There may be more than one family involved in the ownership of an entity, or a family may be into its second or third generation of ownership. For example, the ownership interest might now be held by cousins instead of siblings or even by the children of cousins. In other words, ownership of the interest has become quite removed from the original owner. In these instances, there is a significant chance that a cross-purchase buy-sell agreement will be used—unless the business is recapitalized to have different classes of ownership for each set of families. With a cross-purchase buy-sell agreement, redemption of the interests has a chance of changing the relative ownership holdings of each family. Many buy-sell agreements go to great lengths to maintain equal ownership interests between each family.

Professional Licensing and Other Qualification Requirements

Some types of businesses, like those run by doctors, architects, and lawyers, require the owner to possess licenses or other certifications or qualifications. These requirements could have a bearing on the choice of buy-sell agreements.

Type of Entity

The very form of the entity can influence the choice of buy-sell agreements. For example, if the entity is a family-owned C corporation and there is concern about a redemption being treated as a dividend, the owners may opt for a cross-purchase buy-sell agreement.