Exit Planning and Succession VII - Contingency Planning FAQs
Buy-sell agreements protect a company in the event of the unexpected
February 27, 2017
Editor's Note: This article and the features of AAA Glass & Mirror, Universal Glass Co. and Trident Consolidated Glass, mark the continuation of Glass Magazine’s Exit Planning and Succession series.
Contingency planning is a critical yet often neglected aspect of protecting a business. This process addresses what will happen to a business, an owner’s business stock, and an owner’s family if he or she dies, suffers illness or injury, or simply chooses to leave the business.
It will also account for events such as divorce that might alter ownership agreements, or change an owner’s stake or dependents. At Beacon Exit Planning, we call these unexpected events the four Ds—death, disability, divorce and departure.
Contingency planning is often framed in terms of a buy-sell agreement. This document serves as a roadmap for co-owners, management, an owner’s spouse or dependents, and legal counsel, leaving little ambiguity of an owner’s intentions for the business and their shares in the business after they are gone. It should address issues from valuation formulas to transfer of ownership to continuing leadership.
This article offers contingency planning FAQs that provide an in-depth look at buy-sell agreements, their scope and their importance to a company’s long-term success.
What is a buy-sell agreement?
The buy-sell agreement is a document that outlines an owner’s intentions in the event of any of the four Ds. The buy-sell should be updated regularly and serves as a roadmap for remaining leadership and family. The buy-sell agreement will outline management succession, direct remaining management on how the company can buy back shares from a deceased or departing owner, and will outline financial support for the owner’s spouse and family. The document is particularly important in the event of a sudden death, when the departed owner can’t explain their intentions or assist in transition.
Why is a buy-sell agreement important?
The buy-sell agreement will alleviate a lot of the panic that might arise when an owner departs in difficult circumstances. It can provide a means of addressing continuity at an emotional time, and it gives the management team direction as to how to move forward. It can also serve as a guide when the business owner leaves under voluntary circumstances.
Financial Contingency Planning for Companies of All Sizes
For most small-sized companies, the business is the sole source of wealth and income for the owner and their family. Without a thorough contingency plan, a small business owner may be putting their family’s wealth at stake. The owner should carefully consider what will happen if they unexpectedly die or are unable to work due to illness or injury. What measures are in place to support themselves and their family? What measures are in place to cover things like increased medical bills? A contingency plan, either a buy-sell agreement or a letter of intention, should account for all such considerations.
As companies get larger, valuation and funding become more critical components of contingency planning. Consider, if a primary shareholder dies unexpectedly, the remaining owners will need to find a way to purchase the shares of the deceased.
Remaining company leadership will need to calculate the value of the company and the value of the deceased’s shares. The lack of a clearly defined valuation formula may create disagreement about the value of the deceased’s shares, leading to conflict between remaining owners and the deceased’s spouse and family. Beacon Exit Planning recommends that a company develops a valuation formula with little ambiguity.
Additionally, remaining shareholders must prepare for funding the purchase of the deceased owner’s shares. Funding is often a challenge for companies. As businesses grow in size, they have a lot more value. If a company has to pay for the owner’s shares through working capital, it becomes a burden on the business. Insurance policies that cover funding will make this easier. Companies can consider life insurance or disability buyout insurance.
For large businesses, the buy-sell is all about valuation, taxes and funding. Many of the fundamentals are the same as with smaller companies; there are just bigger dollars.
A key area for the buy-sell agreement in larger companies is outlining how the triggering of the agreement will affect the other owners. How will the buy-sell handle majority shareholders versus minority shareholders?
Are buy-sell agreements right for all types of companies?
The buy-sell is most often used in companies with multiple owners. If properly written, they can provide guidance for a company’s management on how to proceed without one of the main characters in the business.
Companies with a single owner typically do not have a buy-sell agreement. However, it would be prudent for the business to draft a letter of intention. The letter can address several scenarios such as who will be the next CEO, who will address certain [business] relationships and who will be offered an opportunity to acquire the company. Involuntary departure from the business leaves the company, an owner and the owner's family vulnerable. The letter of intention should protect both sides—the management team and the family.
What are the risks of not having a proper contingency plan in place?
Neglecting to thoroughly prepare for the unexpected exposes companies and individual owners to the risks of financial losses, legal conflicts or even business failure. In working with clients at Beacon Exit Planning, we have uncovered provisions and structures that could be devastating to the business owner, the company and the family if something were to occur. The risks often expose millions of dollars in unnecessary tax liabilities or structures that don’t support the owners’ intentions for the business and their spouse after they leave the business. Unfortunately, it is usually too late to change course when a buy-sell agreement is triggered because of death, divorce, departure or disability.
How often should a buy-sell agreement be updated?
The buy-sell agreement is a living, breathing document. It should be updated at the very least whenever there are any significant changes in operations, ownership or lifestyle. However, Beacon Exit Planning recommends that companies put the buy-sell agreement on the agenda of every executive meeting. If it doesn’t need to be changed at that point, it can be put back in a drawer. But, at least the owners and management can be assured it was looked at.
What role do business management and succession play in a buy-sell?
A business owner commonly manages everything from banking to purchasing to customer interactions. The departure of an owner, particularly an unexpected departure, could create major problems for the business if remaining leadership is unable to quickly step in and take over. If, for example, the departed owner was the sole relationship with customers, their departure could lead to a significant devaluation of the company, and customers could start to find other sources of business.
However, management guidelines within the buy-sell are not enough on their own. They must be combined with a long-term succession plan that ensures the company has a strong bench, with managers who can step into larger roles if needed.
Why should spouses be considered in a buy-sell agreement?
Businesses support not only the owner but also their spouse and family. If something happens to the owner, the spouse will face that loss of income. Beacon Exit Planning recommends business owners get the spouses involved so they understand the buy-sell agreement that has been created by the owners. The surviving spouses and family will be bound by the results of the agreement and thus should understand its consequences.
Spousal involvement is particularly important for minority shareholders, where the value of the stock would not compensate the family for the loss of income. We’ve witnessed several instances where spouses have started litigation against a company because of this very situation. Therefore, it is important to have a solid commitment to the buy-sell not only with the owners but also with the spouses. There are some very good buy-sell agreements where the spouses sign off on the agreement. This can eliminate any surprises or potential conflicts down the road.
How can a company make sure that a buy-sell agreement will work as intended?
Beacon Exit Planning recommends that companies perform what we call a fire drill to test the performance of their buy-sell agreement. In the fire drill scenario, business leaders would confer with their team of relevant advisors and simulate a departure from a business owner. The purpose of the exercise is to determine what happens next. How will their exit be funded? What is the payout? Who takes over doing what? Are there options within the agreement that provide for better tax advantages? This will ensure that everyone has a sense of what would happen in reality. It tests the flow and organization of the document, and gives the owner and management an opportunity to modify and make updates.
The buy-sell agreement is a critical document. You don’t want to find yourself having to use it only to find that it isn’t up-to-date or that you don’t understand the owner’s intentions.