The thought of creating a buy-sell agreement may strike a certain amount of trepidation into the hearts of some contractors. The mere suggestion of ownership change can raise delicate issues that are often avoided. But putting off the creation of a well-crafted buy-sell can put a construction company at risk if unexpected circumstances arise.
Understand the purpose
Essentially, a buy-sell sets up parameters for the transfer of ownership interests following a “triggering event.” Perhaps the most common triggering event is an owner’s retirement. But they can also include an owner’s death or long-term disability, loss of license or other legal incapacitation, bankruptcy or divorce.
As mentioned, closely held construction businesses that fail to create a viable buy-sell agreement — or fail to create one at all — put themselves at great risk. Unlike public companies, private ones have no ready or established market on which to sell ownership shares. Also, comparable businesses may be hard to come by and buyers may simply not exist.
These points can create difficult circumstances for businesses — especially when something unexpected happens. Say an owner, in this case a man, suddenly dies. His shares may pass on to his heirs, but how much are those shares worth and to whom can his heirs sell them?
In contrast, a buy-sell will remove uncertainty by stipulating that remaining owners will buy the ownership interest at a price determined by the stated valuation method. Plus, the agreement will help to prevent an unfamiliar and perhaps unwanted owner from suddenly joining the business.
Prepare for valuation issues
The agreement will need to specify a valuation method for appraising the departing owner’s interest at the appropriate time. In choosing a method, you and your fellow owners should carefully define buyout terms and specify the financial data to be used in the agreement.
For example, a sound buy-sell will spell out a required end-date for the financial statements that must be used to appraise business interests following a triggering event. Some also mandate a level of assurance (compilation, review or audit) regarding those financial statements.
In addition, every buy-sell agreement needs to pinpoint a way to accurately appraise the value of each owner’s interest. Some business owners simply plug in boilerplate formulas, but doing so can lead to trouble.
For instance, Company X has a buy-sell agreement stating that the business is worth “four times annual earnings.” But appraisers — and courts, if it comes to that — might argue over the definition of “earnings.”
One could posit that it refers to accounting net income. Meanwhile, another expert might define it as pretax earnings adjusted for items such as depreciation and amortization, interest expense, nonrecurring items, and quasi-business expenses. Ultimately, it’s critical to involve a qualified valuation professional to anticipate and help defend against such conflicts.
Choose a funding method
In most cases, business owners don’t have the cash readily available to buy out a departing owner. So, most buy-sells include an insurance policy to fund the agreement. And this is where several different types of agreements come into play.
Under a cross-purchase agreement, each owner buys life or disability insurance (or both) that covers the other owners. Should one owner die or become incapacitated, the other owners collect on their policies and use the proceeds to buy the deceased or incapacitated owner’s shares.
Another type is a redemption agreement. Here, the company (not each owner) buys the insurance policy and acquires the deceased or incapacitated owner’s shares. This approach can really help businesses with multiple owners, because fewer policies are needed.
In some cases, a company will create a hybrid buy-sell that combines aspects of the cross-purchase and redemption approaches. These agreements may stipulate that the business gets the first opportunity to redeem ownership shares. And, if the company is unable to buy the shares, the remaining owners are then responsible for buying the departing owner’s interest.
Creating a buy-sell isn’t easy, but it can protect your construction company from costly ownership conflicts down the road. Your Castellano, Korenberg tax professional can help you get the process started.