By Cliff Ennico
“I started a business with two partners back in the 1990s. We set up a closely held corporation for the business, and signed a Shareholders’ Agreement.
The three of us have gotten along well over the years and so we really haven’t had to look at the Agreement all that much. But about a month ago, one of my partners, who just celebrated his 70th birthday, announced his intention to retire from the business and asked that we buy out his one-third interest.
We dug out the Agreement and showed it to our attorney, who told us it didn’t say what to do when a partner retires! Why did we spend so much money on this Agreement when it won’t work now that we really need it?”
When setting up a corporation or limited liability company (LLC), it is very important to have an agreement – called a “buy-sell agreement” — providing for the transfer of each owner’s equity interest to the company and/or the other partners upon the occurrence of certain events. Sometimes the “buy-sell agreement” stands alone but often it is part of a much larger agreement (called a “shareholders’ agreement” for a corporation, and an “operating agreement” for an LLC).
I have reviewed thousands of buy-sell agreements in my career, and I’m sad to say I have seen few forms that work well.
The good news is that you and your partners get along well, so it really doesn’t matter what your Agreement says (or doesn’t say). The three of you should sit down with your accountant, go over the numbers for the business, and I’m sure you will work out a buyout formula for your retiring partner that will be fair and won’t burden the company.
But what if you didn’t get along? When business partners can no longer communicate, that’s when a buy-sell agreement has to have teeth.
If you have a buy-sell agreement for your business, now is the time to correct any deficiencies. Read the document, and ask: “if one of us had to leave the company, is it crystal clear in the agreement what we have to do and when?” If the answer is “no” or “I’m not sure,” your attorney should review and update the agreement.
What should the agreement say?
First, there should be specific provisions requiring a repurchase of an owner’s interest upon each of the following events:
- A partner wants to sell his interest to someone outside the company for an agreed upon price;
- Someone voluntarily leaves the company (i.e. quits), disappears or retires after reaching a specified age (customarily age 65, but 70 is increasingly common);
- Someone is “voted off the island” by the other partners because he’s not pulling his weight, or has committed a crime such as fraud or embezzlement that makes him no longer trustworthy;
- Someone dies or becomes permanently disabled (i.e. no longer physically or mentally able to work in the business);
- Someone files for bankruptcy or otherwise loses his shares in a court proceeding; and
- Someone is forced to transfer shares to an ex-spouse in a marital divorce or separation proceeding.
If your agreement doesn’t cover each and every one of these situations, it’s time for an update.
Second, the purchase price the corporation or other remaining partners must pay in each of these situations must be stated with 100 percent crystal clarity.
If the company is a going concern, the purchase price for a departing partner’s interest should be a multiple of the company’s pretax earnings (“earnings before income taxes,” or “EBIT”). Two to three times the company’s average EBIT over the past three to five years should yield a fair result for most businesses.
If the company is not profitable, the value should be two to three times the company’s average gross sales over the past three to five years.
If the company is an LLC or subchapter S corporation, the purchase price should be the “greater” of one of the above measures or the “capital account” of the departing partner.
If the departing partner has engaged in illegal or fraudulent activity, or if the company is truly worthless, the purchase price should be the “book value” of the company or a nominal value such as $100.
In each case, the value should be determined by the company’s accountant in her “sole discretion,” and payable in monthly or quarterly installments over a period of five to 10 years to minimize the impact on the company’s cash flow.
Beware buy-sell agreements that “kick the can down the road” by requiring an independent valuation of the company (or a “Three Stooges” appraisal where each side appoints an appraiser and the two appraisers appoint a third if they can’t agree) at the time a triggering event occurs. Valuations are extremely expensive and time-consuming, and generate huge fees for the “experts” (which is probably why lawyers love these provisions so much).
Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books. Follow Cliff: @cliffennico.