In Georgia alone, roughly 56% of all small-business owners are age 53-71 according to the Exit Planning Institute. We undoubtedly have an aging business population, which means there is a lot of potential for business transfers. However, the reality is that nearly 81% of all business owners have no formal written transition plan.
One of the most common business transfers is when an owner sells ownership interest to his executive team or key employees that help build the direction and success of the company. This transition may be understood amongst the parties involved or even in process with ownership shares given as yearly bonuses. Unfortunately, a lot can happen in the time a gradual ownership transition takes place.
Death, disability, and divorce can all change an ownership transition timeline, which is why a buy-sell agreement should be part of the overall succession plan. A buy-sell agreement puts down on paper who specifically can own shares of the business and how to value those shares. It is a formal agreement between shareholders of a closely held business that specifies the terms and prices of a buyout when one or more shareholders want or need to sell.
For example, what if an owner of the company goes through a divorce—will an ex-spouse gain ownership shares? Potentially a business could then have a set of owners who are not in agreement from the get-go. A buy-sell agreement allows for a way out so that the intended ownership isn’t diluted. If an owner were to become disabled for an extended period and unable to contribute to the business, how long will the other owners be able to assume the extra responsibilities while the disabled owner continues to be paid? If that key owner has specialized skills, a new employee may need to be hired to fill his shoes. A buy-sell agreement can discuss the needed funds to replace a key employee. If an owner were to die, a buy/sell agreement can specify how the transition should proceed. Additionally, because funding for these agreements is typically arranged when the agreement is executed, the business can expect that funds will be available when needed in addition to providing the deceased owner’s estate with liquidity that may be needed for expenses and taxes.
A buy-sell agreement can cover numerous possibilities, making a transition easier should something unexpected happen. Furthermore, these agreements are not static. What may have worked when the company was initially getting off the ground, may not be appropriate 10 or more years down the road.
We often see companies with buy-sell agreements in their operating agreements. Quite often, it’s specified that the value of the business is based on simple book value, which can significantly underestimate a business’s value. Circumstances change over the course of business, and ideally, the company is more valuable after several years in business. Therefore, adjustments need to be made to the buy-sell agreement. If these agreements are funded with insurance, the coverage levels may also need to be adjusted to reflect the current value of the business.
Keep in mind, a buy-sell agreement is designed to provide for business continuity and smooth transition when owners want or need to leave the company. If the business has changed significantly an update to the buy-sell agreement is necessary to protect the value created over the life of that business.
If you have questions regarding your business succession plan, the experts at Henssler Financial will be glad to help: