If you have two or more stockholders in your business, or if you are thinking about adding a new stockholder, then the information in this article is for you. One of the most important, but least understood, documents for business owners is the buy-sell agreement. This agreement is sometimes called a shareholder’s agreement or a stock redemption agreement. At Castle Wealth Advisors, we read dozens of these agreements every year and I am constantly surprised by the information that is missing.
Important trigger points that should be carefully defined in every one of these documents are death, divorce, disability, personal bankruptcy, termination, retirement or the selling of stock. These are the events that happen within closely-held family businesses every year.
Old Documents Are Dangerous
If you already have a buy-sell agreement, chances are it was prepared 10 or 20 years ago when all the stockholders were much younger and the company was worth less than it is today. An old buy-sell agreement usually talks about death, but most of them do not cover all of the other trigger points. It probably does not talk about the divorce of or disability of a stockholder. If a stockholder gets divorced who gets to own the stock?
Are all of these trigger points spelled out in your agreement? If a stockholder who is working every day in the company becomes disabled and unable to work, what happens to their stock? If they are disabled for one or two years does the company continue to pay their salary? If a stockholder dies, do they receive the value written in the document 20 years ago? Are they paid all at once or over time?
Buy-sell agreements should have the value of the stock updated in the back of the document every one or two years. Rarely do I see this happen. If the price of the stock in the document is low, then the surviving stockholders are the winners. If the price of the stock in the document is too high, then whoever dies first is the winner.
Three Types of Documents
The first type is of document is called a cross-purchase agreement. This is commonly used when there are only two stockholders. In simple terms, the agreement should cover all of the trigger points mentioned above and if something happens to one of the stockholders the other stockholder redeems the shares either immediately, or they are paid for over time. The stockholder who is leaving the company will have liquidity, and hopefully a profit if the business has gone up in value. The remaining stockholder will receive an increase in his basis for the purchase price of the stock and the remaining stockholder will be the 100 percent owner from that point on.
The second type is of document is called an entity-purchase agreement. This agreement also covers all of the important trigger points, but it indicates that if something happens to a stockholder then the corporation is the entity that will purchase the stock from the stockholder that is leaving. The agreement should have an updated price for the stock and it should also spell out the terms on how the stock is to be purchased.
If the stockholder leaving is disabled or is deceased, will the company pay the full price all at once, or will the company pay 20 percent down and the remaining 80 percent over five or 10 years? If a promissory note is used, what will the interest rate be? What security or collateral will the leaving stockholder have until the note is paid off?
The third type of agreement is called a hybrid agreement. This is most often the best type of buy-sell agreement to be used in a business where there are two or more stockholders. This agreement gives all of the stockholders a lot of flexibility when it becomes time to purchase stock from the individual that may be leaving the company. A hybrid agreement allows all of the remaining stockholders and the corporation to use the best tax and financial options to redeem shares from someone leaving.
If the corporation has a lot of cash and the other stockholders do not, then perhaps the corporation should redeem most of the shares that are coming back to the company. On the other hand, if the stockholders have more liquid assets than the corporation, then perhaps they should purchase most of the stock.
If it is important that someone maintain voting control of the company, then that person should redeem a high percentage of the stock and the corporation and other stockholders should purchase less.
Typically, hybrid agreements operate in three steps. When stock is repurchased, the corporation may have the first option to purchase some of the shares. In step two, the remaining stockholders have the option to purchase some or all of the shares. In step three, the corporation comes back to purchase any remaining shares that were not acquired in steps one or two. This gives all of the stockholder’s maximum flexibility to purchase stock that becomes necessary for them to have in order to maintain voting control, and also take advantage of the corporate and individual tax brackets.
Unforeseeable situations sometimes occur, such as one of the stockholders having an unexpected illness or a debilitating accident.
If you do have an agreement, now would be a good time to review it and make sure all of the trigger points are addressed, and that it also answers the following questions: What is the price of the stock outlined in the document? Over what period of time is the stock to be purchased when it is redeemed? Do you have any life insurance on the stockholders? How is the term disability defined? If someone is unable to come to work and do their normal job for 12 months, then most companies would consider them disabled. Some documents require one, two or three physicians to declare you disabled. Some document require an insurance company to classify you as disabled. Those are all good ideas, but the simple fact is that if you cannot come to work and do your normal activities for six or 12 months, then you should be classified as disabled. If the company is still paying all of your salary and benefits for that time period, then there should be a termination point.
When it is time to put a value on the stock, hiring an independent valuation company that knows your industry should be considered. Is there a formula outlined in the buy-sell agreement that is used to value the stock that everyone accepts?
Twenty years ago, your company was worth much less and purchasing the stock would have been easier. Now that the company is more valuable it would be more difficult for the corporation or any of the stockholders to write one check and buy the stock. Perhaps the stock should be redeemed by using a contract that calls for monthly payments over 10 or 15 years.
For those of you who are stockholders in a closely-held family business, the buy-sell agreement may be the most important document for every stockholder. It controls stock that is very valuable and it also defines how you are going to be treated when one of those trigger points is activated, for your benefit.
Anyone with a 20-year-old buy-sell agreement should sit down with a qualified corporate attorney and start defining all of the trigger points. If you do not have an attorney, you could send that document to Castle Wealth Advisors and we will review it for you. Remember, old documents are dangerous.
Gary Pittsford, CFP®, is president and CEO of Castle Wealth Advisors, LLC and is a contributing writer for The Hardware Connection. Castle specializes in helping families and closely-held business owners with valuations, succession planning, estate and income tax analysis and retirement income security. Castle’s senior partners work with clients throughout the country in making logical decisions that help them fulfill their personal and business financial goals. For more information visit www.Castle3.com, call 1-888-849-9559 or e-mail Gary directly at Gary@Castle3.com.