In this blog, we conclude our discussion of the most common problems that typical Buy-Sell Agreements create for the business owners who sign them. These problems can jeopardize the business’ very existence and make it difficult for the owner’s family to maintain its financial security. When owners learn that their Buy-Sell Agreements can destroy their businesses and leave their families scraping by, they usually want to fix them right away.
So, let’s examine four more common problems apparent in a typical Buy-Sell Agreement.
The Buy-Sell Agreement Doesn’t Address the Situation
Most Buy-Sell Agreements are too simplistic to manage the personal complexities of the owners who sign them and their relationships with the business, any co-owners, and the company’s workers. For example, companies with multiple owners often don’t want to treat all owners in exactly the same way. Another example is how a Buy-Sell Agreement accounts for an owner who is uninsurable (e.g., due to a pre-existing condition of some sort). In family businesses, non-business considerations—such as treating non-business-active children fairly—may affect the design of the Buy-Sell Agreement.
In all of these situations, advisors must move beyond standard Buy-Sell planning. To craft a fitting Buy-Sell Agreement for an owner, advisors should examine the goals of each potential party to a Buy-Sell Agreement and recommend tailored solutions. For example, in a business with multiple owners of varying ages and ownership interests, it may be appropriate to have a simple buy-back agreement for a junior owner that requires a mandatory sale and purchase if that junior owner terminates employment for any reason. For a senior, retirement-inclined owner, a redemption or sale to one or more of the other owners could be designed to initiate a partial buyout now and a total buyout in the event of that owner’s death or incapacitation.
In short, knowing how to plan a proper Buy-Sell Agreement often goes far beyond simply creating one. Proper Buy-Sells are a living document and must be treated like one.
The Buy-Sell Agreement Uses a Cookie-Cutter Valuation Formula
When business owners first create Buy-Sell Agreements, they use common valuation methods to determine what the business is currently worth. This can include a simple agreed-upon value or book value. However, these methods are at best inaccurate and at worst harmful as the business grows in value.
Most business owners don’t review their Buy-Sell Agreements at all, let alone once a year. The staleness of these Buy-Sells combined with their inapplicable valuation formulas can leave owners in a lurch when they need their Buy-Sells most.
Ultimately, the best method of determining value as the business’ value grows throughout the years is getting an appraisal from a credentialed business valuator.
Some business owners will resist paying money for a proper valuation. They might say, “I paid for this already, and I won’t do it again.” It’s important that the business owners understand that the ROI of getting a proper valuation far outweighs the upfront cost.
The BSA Is Outdated
Buy-Sell Agreements may not have sell-by dates, but they should. When they are filed away and unreviewed in the context of current business circumstances (e.g., changes in value and ownership) and the changing desires of owners (e.g., one owner wishing to transfer ownership to a business-active child), they can produce some ugly surprises.
Owners rely on Buy-Sell Agreements to manage many emotionally charged situations. If those agreements don’t account for changes in the business, they cause huge problems for everyone involved. That’s why advisors should periodically review business continuity planning from the perspective of the business and each of the owners. To do otherwise is to plan for a past that no longer exists, rather than a future that’s inevitable.
The Buy-Sell Agreement Is Poorly Implemented
If insurance funding is lacking or insufficient, or information related to beneficiaries and/or ownership is incorrect, having a Buy-Sell Agreement may be worse for all parties than none at all.
Takeaways
- Most businesses become more complex and valuable as they mature. It is advised that the owners should update their Buy-Sell Agreements to address added complexity and account for significant increases in value. When a Buy-Sell Agreement does not match the complexity of a business, it can create more problems than it solves.
- Buy-Sell Agreements are valuable tools, but their scope is limited to the exchange of ownership for money. They don’t account for other owner-based issues that arise when an owner dies.
- Implementation details, like insurance policy beneficiaries, matter. If they aren’t correct, no Buy-Sell Agreement can operate the way its signers intended.
Conclusion
Even well-drafted Buy-Sell Agreements can do the following, unintended harm:
- Provide only partial replacement of the deceased owner’s income stream, rather than full replacement.
- Fail to protect a business from the loss of the personal guarantor (or the owner indispensable to business operations).
- Provide only partial solutions for surviving and deceased owners (and their families).
- Ignore or pay lip service to the likeliest transfer events: retirement or another type of lifetime departure.