By Barry van Heerden
As previously indicated in parts 1 and 2, Buy/Sell Agreements, which are also called Business Wills, are means of providing a legal mechanism by which the interest of one party in a business is transferred to the other (or its estate) with the minimum of disruption to the business and the parties involved in the business.
The following are some of the issues that should be addressed in a Buy/Sell Agreement:
- The parties to the Agreement (including spouses and beneficiaries);
- The events that will trigger the working of the Agreement;
- Put and Call Options;
- How to determine the value of the business and a partner’s interest in the business;
- The most appropriate funding mechanism to finalise the transfer of the business.
In this article we will discuss the two most important elements of a Buy/Sell Agreement:-
- Determination of the value of the business; and
- The funding options available for the purchase of a partner’s interest in the business.
1. HOW TO DETERMINE THE VALUE OF A BUSINESS FOR PURPOSES OF A BUY/SELL AGREEMENT
This is arguably the most important part of the Buy/Sell Agreement. By getting this right all disputes regarding the value of a deceased partner’s interest in the business are eliminated and all parties involved will know exactly what is going to happen (from a financial perspective) if an event occurs [*see Part 2 in relation to events].
Generally speaking there are 3 methods that may be used to provide an acceptable way to agree on a realistic business value:
1.1 Agreed Formula
The business owners in consultation with their accountants may agree to use a specific formula that reflects an industry standard or a formula that is appropriate to the business in question.
If a formula like this is used it is important to review the formula on a regular basis to ensure it remains current and relevant to the business.
It must be noted that the use of an agreed formula may create an issue depending on the means of funding that will be available for the purchase of a deceased’s interest in the business. If insurance is going to be used (as discussed below) to fund the purchase/transfer of the business, the agreed formula should be used to determine the value from the commencement date of the Buy/Sell Agreement and thereafter on a regular basis. It is important not to apply the agreed formula only on the happening of an event.
1.2 Agreed Dollar Value
The business owners agree to a specific dollar value of the business. Usually the agreement provides for a review of this amount on a regular basis depending on the type of business. This may take place every quarter, six months or yearly.
The effect of an agreed dollar value method is the same as if an agreed formula is used from the commencement of the Agreement and is reviewed on a regular basis.
1.3 Independent Valuer
The parties may decide to have the value of the business be determined by a valuer on the happening of an event. The concern with this method is that the parties will most probably not be able to use insurance as a funding option. The main purpose of a Buy/Sell Agreement is to provide certainty and this method of valuation falls short in that regard.
In determining the value of the business and the ultimate price a departing partner should be paid for its interest in the business it is also necessary to consider the following:-
1. The debts of the business, including any overdraft and/or bank loans;
2. Personal guarantees that were provided by the departing partner and replacement of same;
3. The financial costs to replace the departing partner.
Where the parties have agreed upon the value of the business and the purchase price payable by the continuing partner, the next important element of a Buy/Sell Agreement is to put arrangements in place to fund the purchase of the departing partner’s share in the business.
2. FUNDING OPTIONS
There are several options available and it depends on the financial status of the business and the partners which option will best suit the funding of the purchase of a deceased partner’s interest in the business.
The following are some of the options that may be available (this is not exclusive):-
1. Enterprise funding. This means there is enough cash available in the business to provide for the purchase price.
2. Bank funding. There is enough credit available from a financier.
3. Vendor finance. Where the Agreement allows for the payment of the purchase price on certain terms and conditions agreed upon between the parties over a period of time.
4. Life insurance.
It is important to carefully consider which funding option will suit the business and the remaining partners in the business the best asset as it is conceivable that the wrong funding mechanism may bankrupt the remaining business partners.
It is our experience that life insurance is a common source of funding in a Buy/Sell Agreement. It takes away any financial stress on the business and the remaining business partners and creates a fair, reasonable and quick finalising of the transfer of the business.
In essence, each partner takes out life insurance equal to the value of its interest in the business as agreed upon in the Buy/Sell Agreement. It is therefore preferred that the partners agreed on a specific dollar value or an agreed formula but only as discussed above.
The Buy/Sell Agreement provides that where an event occurs and the life insurance pays the proceeds to the relevant partner, its estate or beneficiaries, the proceeds received by the partner, his estate or beneficiaries will be deemed payment for his interest in the business.
His part of the business will then be transferred to the remaining partners without the financial strain to pay any additional amount to the deceased partner and/or his estate.
When using life insurance as a funding mechanism it is important that the insurance policies be reviewed on the same basis that the Buy/Sell Agreement will be reviewed to ensure that the amount insured always equals the value of the as agreed upon between the business partners from time to time.
It is also important to discuss the ownership of life insurance policies in that there are different ownership structures that may be used. The preferred structure is self-ownership but we always discuss this with the business partner’s insurance broker to ensure the correct structure is used for the insurance policies.
It should be noted that an insurance policy for these purposes must be supported by a Buy/Sell Agreement. An insurance policy on its own without a written agreement between the business partners will not be enough and may potentially have no effect on the transfer of a part of the business to the remaining business partners.
Where business owners have agreed upon the value of the business and insurance is in place to cover that agreed amount, it provides comfort and certainty to everybody involved in the business that financial strain will not have an effect on the continuance of the business when an event occurs.
Should you wish to discuss the succession of your business and the effect they may have not only on the other partners but also your relatives, please contact our Property & Commercial Department manager Holly Gilholme on 07 5506 8202 or email firstname.lastname@example.org for an appointment.
We conduct regularly seminars on business succession and specifically Buy/Sell Agreements to accountants, business advisors and their clients. If you feel you or your staff/clients may benefit from such a presentation please contact us to arrange.