Introduction:
Bought and Sold Agreement is a contract that is legally binding and specifies how the shares of the partner in a business may be redistributed in case of demise or otherwise leaves the business. It is more commonly known as Buy-Sell Agreement. In most circumstances, it deals with the number of shares sold to the remaining partners or in a partnership. It is the most valuable tool for a company to have in order to protect its value in cases of death, divorce affecting the owner’s income and vital business savings. The absence of this agreement can harm and destroy a business. This keeps a business protected and the family of the deceased also gets fair compensation. However, many companies fail to draft this agreement and it becomes critical to create it. It is one of the methods for determining the value of the business.
Proprietors, partners and closed corporations are the ones who commonly use this method to make sure the smooth transition of ownership title when a partner dies or gets out of the business due to any reason. By using the predetermined formula the shares are sold to the remaining members and company. However, in cases of death, the estate shall agree. There exists a cross-purchase agreement in which the remaining owners purchase the business’s share and a redemption agreement in which the entity buys all the shares. Some opt for a hybrid of two. In order to ensure the availability of funds, the partners jointly buy the life insurance policies. A typical form of agreement might prescribe to sell back the deceased partner’s interest to the business or the left owners.
Significance of Having Buy-Sell Agreement
Protection Against Divorce and Creditors
The stocks of a company can be claimed by discontented spouses in divorce proceedings. Such a fact becomes very important to a company. It might so happen that any wrong person can claim and acquire the stock.
Split ownerships of stock tends to destroy the company even if the divorcee couple seeks to save it. The right to vote in the house has split with the ex-spouse, seeing which the other partners may end up running the company effectively.
Family Protection After Death
The death of a partner due to any unforeseen circumstances may lead to a shock. This kind of circumstance often leads to rancour within the company and watch the long relationships end at such bitter resentment. Hence, a good buy-sell agreement can help resolve these sorts of issues without affecting the real value of the company and protecting the dignity and goodwill of the person deceased.
Bankruptcy
A bankruptcy trustee is elected and appointed to evaluate how to liquidate assets and pay off a portion of the debt. In quite a few cases, the bankruptcy trustee could liquidate the owner’s interest and sell off the assets in order to pay off the debtor’s debts. A buy-sell agreement shall address the possibility of bankruptcy and notify the other owners before the debtor files bankruptcy. The valuation of the assets in such cases may be based on the opinion of a professional appraiser. The parties could also base the valuation on a specific formula.
Disability
If the partner becomes so disabled that he is no longer being able to contribute to the company, the results might be unfortunate. It is practically not possible for the family, owning the stock in a non-public company to seek buyers and who are ready to purchase it for any real value. Hence, provisions should be mentioned in the agreement so that the valuation can be done easily.
Variations in Buy-Sell Agreement
Parties to a contract can change the contract orally or by the way of a written agreement. For this variation to be successful and effective there must be a valid agreement and mere notification by one party won’t work. There must be some sort of supporting consideration to this agreement. The consideration could be in the form of new benefits granted by each partner to the other party, abandonment of existing rights, if the contract is breached the parties shall assume their additional obligation, etc.
Effects of Variation and Their Solution
Estate Planning Situation
Valuation of Shares for Estate and Gift Tax Purposes are the ones where the valuation process outlines the value of the deceased owner’s share for gift and estate tax purposes. Providing liquidity when estate taxes are due. The family businesses represent higher illiquidity of assets which may comprise of owner’s net worth. Hence the process of paying taxes seems to be crippling in nature. By creating the agreement the families along with their attorneys coordinate the techniques which are effective and minimise the future tax burden.
Personal Situations
To prevent the bankruptcy problem of a partner there should be a clause added to the agreement that the partner going to be bankrupt must notify the other partners and company before filing for bankruptcy. This gives a chance to other partners to buy the owner’s share at an agreed price and by this, the control remains protected from the external factors and this also satisfies the trustee’s interest in the company.
Governance Situation
In a company where there are captive minority or non-voting owners, the company might feel nervous about the future value of its assets. Hence. if the shareholder doesn’t feel secured and wish to move out, he can do so by selling his shares. However, this is not so possible in private companies. This is why there should be a buy-sell agreement that can serve to dispute resolution.
Case Laws
Matter of the Estate of Maurice F. Frink[1]
The Lowa Court of Appeals took into consideration that whether a buy-sell agreement that needed the redemption of the decedent’s stock at “book value” was ambiguous or not. The beneficiaries claimed that “book value” in real meant “fair market value,” which shall result in greater value for the beneficiaries. “book value” was not an ambiguous term in the eyes of the court. It was found that different dictionaries consistently drew the difference between “book value” and “market value.” Furthermore, it was noted that the company had continuously used “book value,” as defined under generally accepted accounting principles when it made prior redemptions. Thus, despite the major and makeable difference between “book value” and “market value,” the court enforced the buy-sell agreement.
Etienne v. Miller[2]
The trust documents specially referenced the obligations under the buy-sell agreement. The beneficiaries fought for the enforcement of the buy-sell agreements because they provided for below the market value prices and would, thus, create an onerous federal estate tax burden. The court found that in this case, the trustee should enforce the agreements, because the trust documents amounted to the purchase of the interests and, therefore, non-enforcement of the buy-sell provision would fail the whole purpose of the trust. In order to draw a conclusion, the court rejected the argument of the trustee breaching his fiduciary duties to the beneficiaries if he complied with the buy-sell provision because it clearly provided for below the market values.
Advantages
- The company uses its life insurance to purchase the deceased owner’s equity shares.
- The policies are owned by the company as a beneficiary. Hence, there is the need for only one policy required for each owner of the company.
- The premiums of insurances are paid by the company itself. Therefore the difference between age and health conditions of the owners doesn’t matter and is not of importance.
- The insurance policies received by the owner are non-taxable
Disadvantages
There are larger taxable capital gains when the owner who is alive sells his equity. while the deceased owner’s equity remains the same on a tax basis.
- Some of the state laws might prohibit the company from purchasing the equity of the deceased partner if it lacked the basic requirement of sufficient funds.
- The proceedings of life insurance depend on the claims made by the company’s creditors.
- The premiums bear by the company are not deductible as a business expense.
Conclusion
There are certain clauses that are especially very useful in a buy-sell agreement. It is very clear and considerate that an arbitration clause for such a business contract clearly words the warning to all the spouses in the power of executing the contract so that they clearly understand that the court of divorce would lose the jurisdiction if the agreement is executed by them.
By far the most important and highly critical clause remains that of stock evaluation and terms of sale. in order to create an acceptable formula and terms, one requires brainstorming. Each stockholder must be well acquainted with the fact that he/she may be selling or buying the stock. Thus, it requires a fair formula that takes into account all the changes that occurred in the business environment and a realistic evaluation of the tangible assets. Ultimately it is the business people who are very much familiar with the company’s value and are best suited to choose between all the possible methods available.
Hence, there exists the need to form a buy-sell agreement at the very beginning of a new business so that there shall be no such problems or issues related to the share evaluation and all. The advice and consultancy of a professional must be taken while drafting such an agreement as he/she can best assist in making the decision of how who and how often the business shall be valued. Financial consultancies are also important in order to know how subsequently a payment shall be made with respect to the financial health of the business before and after payout.
References:
[1] No. 6-433 (Iowa App. October 25, 2006)
[2] No. F049110 (Cal. App. 5 Dist. October 23, 2006), unpublished
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