Benefits of Pre-Exit Planning Part II

In our last newsletter, we focused on the value and profit enhancement benefits of beginning the exit planning well in advance-five years or more-of an owners target exit date.

This month we'll address risk mitigation.  One of our clients refers to this quaintly as the "hit by a truck scenario."

The most important risk management step in an exit planning context is a Buy-Sell agreement.  In different contexts, this might be called a shareholders' agreement, a partnership agreement or a members' agreement or an operating agreement.  It SHOULD lay out the rules of engagement for the multiple owners of a business, including the manner in which one can or must buy out another in case of a triggering event.

We discussed a bad buy-sell scenario in our April 2010 issue but we can go more in depth here.  Triggering events in a well written buy-sell will include:

·         Death

·         Disability or Incapacity

·         Divorce

·         Desire to sell

·         Irreconcilable differences

As you look at these, it should become clear that death is the easy way out.  The others all will require a degree of definition, negotiation and will have room for disagreement.  Consider these examples:

·         If Shareholder A becomes disabled, how is disability defined and how long must A be disabled before and the buyout is enacted?  Who is the final arbiter in this circumstance?

·         Is your document silent on what the Shareholders are to do when Shareholder A's wife's attorney is demanding A sell his shares to meet his obligations under a divorce decree?

·         What is in your agreement to keep shareholder A from an outsider if you fail to meet his price when he wants to sell?

·         What is in your document that allows you to oust an obstructive or non-productive shareholder?

With these scenarios, you must think that negotiating these items early in a business relationship is about as appealing (and romantic) as negotiating a pre-nuptial, but you absolutely must do it.

Does the agreement have a valid valuation formula?

Some agreements we see have the remaining shareholder buying out the departing shareholder at book value.  This, of course, is almost never the true value of the shares.  The agreement should have a valuation formula or methodology for periodically resetting the value of the business.  Or it  could have a provision that requires a valuation by an accredited appraiser at a date certain done such as every five years and again at the time of a triggering event.  This way the agreement doesn't get stale.

If life insurance is used as a liquidity tool for the death event, it is highly unlikely that the business value at the end will match the insurance proceeds exactly.  The agreement should address how a shortfall should be made up-installment payments are usually the answer.  If the insurance proceeds are more than necessary for the buyout, the excess proceeds will typically remain with the policy owner.  But this can vary the type of agreement that is written and the language in the contract.

Buy sell agreements are probably the most important and most overlooked document that a co-owned business can create.  No one ever wants to do contingency planning, but stories of partnerships that end badly due to unexpected events litter the highways of corporate America.