FAQs About Buy-Sell Agreements

July 14, 2017 10:37 AM

Legal experts share the basics of creating this vital estate-planning document

A good rule of thumb for succession planning is before you go into business with someone, you should know how to exit. Even if you didn’t set up a such provision on the front end, now is the perfect time to establish one. A buy-sell agreement is a legally binding agreement between co-owners of a business that spells out how a business transfers if a co-owner is forced or chooses to leave the business.

“Planning on the front end is the best recipe for avoiding litigation or hard feelings down the road,” says Paul P. Morf, attorney with Simmons Perrine Moyer Bergman PLC in Cedar Rapids, Iowa. “I believe every entity owned by two or more people should have an ownership agreement of some kind.”

Why should farmers have a buy-sell agreement?

“A buy-sell agreement is a no-brainer when unrelated parties are in business together or when brothers or cousins farm together,” explains Polly Dobbs, owner of Dobbs Legal Group in Peru, Ind. “Upon certain triggers, an owner may be contractually obligated to sell his or her interests to the company or other owners. The company or other owners may have the option to buy those interests or be required to do so.”

 A buy-sell agreement also defines what group of people or trusts can buy or inherit shares of a business, Morf adds. “This not only protects the family from unwanted partners—it avoids disputes over issues such as an owner’s spouse inheriting shares,” he says. “Failing to create an exit plan can lock families together in a mechanism that may have worked for three brothers but works poorly for 25 second-cousins two generations later.” 

What events trigger the use of a buy-sell agreement?

In drafting your agreement, you will spell out what events cause it to be executed. Common triggering events include death, disability, retirement, divorce, bankruptcy, an attempt to sell interest to outsider, competing against the business or involuntary termination of employment, says Dobbs, a member of Farm Journal’s Legacy Project advisory board.

How do you determine the purchase price for assets?

Upon a triggering event, a buy-sell agreement defines the price for shares of the business and assets. The purchase price can be different depending on trigger, Dobbs says. A farm owned by an entity will need two values: appraisal of the farm land, improvements, equipment and assets; and a business valuation of an interest in the entity with appropriate discounts.

The purchase price can be based on an agreement by the owners, a formula or an appraisal. In defining the buy-sell price, clients often allow family members who are buying out an exiting owner to do so at a discounted valuation and over a period of years, Morf says. “In my experience, a good business valuation professional will apply a discount of 30% to 45% to non-controlling interests in family corporations and LLCs to reflect lack of control, lack of marketability and additional discounts for built-in tax liability,” he says.

How do you define a buy-sell agreement for a multi-family operation?

If three brothers will be transferring shares to each of their own children, Morf suggests treating each of the three “families” as a separate ownership group.

For example, brother David has three children: Abe, Bill, and Cooper. If Cooper dies without children leaving his shares by will to his spouse, the agreement can provide that Abe and Bill would have the first right to buy those shares from Cooper’s spouse, before they were offered to David’s brothers or their children. “Then David’s family will not be diluted if they don’t want to be,” Morf says.

What are common mistakes farmers make concerning buy-sell agreements?

“An old or outdated buy-sell can be worse than no agreement at all,” Dobbs says. If you are updating an old version or creating a new one, she suggests having your attorney and CPA walk you through the agreement and the formula for valuing assets, liabilities, and ownership interests. “Then have everyone sign off on it,” she encourages.  That way everyone knows what his or her interest is worth; and there won't be any surprises down the road.

The valuation process is critical, Morf agrees. “Many old agreements use ‘book value’ or ‘agreed value’ to determine price, and it is rare book value is reflective of actual value or that parties regularly update their ‘agreed value’” he says. “Those issues have led to numerous litigated cases involving farm agreements. Also, the IRS is generally not bound by the value specified in a buy-sell agreement, so using a value divorced from fair market value can have unanticipated estate tax consequences.”

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