Craft a strong buy-sell agreement to keep the business in the family
It’s a dream for most families: build a successful business and eventually pass ownership of the company to the next generation and, hopefully, many generations after them.
But too many business owners fail to take important steps to ensure their business is handed down according to their wishes. Many have relied on good faith or on agreements based on a clause commonly referred to as “last man standing,” meaning whoever is next in line will inherit and continue the family business. Today, however, because of the changing American family, a proper buy-sell agreement is essential.
Over the years, it’s become more challenging to sustain family business ownership. One challenge involves the increased prevalence of blended business families. The stepchildren may not necessarily share the values of the business founder or the founder’s direct descendants.
In addition, the globalization of modern society means more family members are moving away from the family firm’s hometown. This is most likely to be a factor in later-generation companies that are owned by a consortium of cousins spread over the country or even the globe. Generally, the older the company, the smaller the percentage of family owners who work in the business. The “insiders” and “outsiders” often have different liquidity needs.
There are different means to overcome these challenges, and families can choose from a variety of options. For example, a buy-sell agreement can specify which family members are eligible to own stock (such as bloodline descendants only) and can prohibit the sale of stock outside the family. It’s critical to communicate clearly with your estate planner to ensure there is no uncertainty or confusion about your intentions.
Limitations of ‘last man standing’ agreements
“Last man standing” buy-sell agreements can be fraught with problems. Here’s an illustration of what could go wrong:
Three brothers own and operate a family business. One of the brothers has sons who are involved in the day-to-day management and operation of the business. The other two don’t have children in the company. Years ago, the brothers drew up a “last man standing” buy-sell agreement.
The brother with sons in the business dies and the company buys out his stock, transferring it to the two surviving brothers. His sons are left with no ownership in the business they helped build. They want to challenge the terms of the agreement, but they have no legal basis for a challenge.
Assuming that the current “last man standing” agreement remains in force, eventually one brother will own 100% of the stock. Without a good succession plan in place, the company could be sold outside the family upon his death. There’s no guarantee that the interests of the nephews working in the business would be the main consideration. What if the uncle’s heirs think they could get more money from selling to a third party? They have the option of keeping the business in the family, but it’s not ensured that the family business legacy will be continued.
This happened to a real-life family I know. That family had put a “last man standing” agreement into effect before the second generation joined the business. While it might have made sense then, it should have been reviewed when circumstances changed — a simple solution that unfortunately never was implemented. This example illustrates why it’s essential to conduct regular reviews of your buy-sell agreement (and other key family business documents).
Restricting ownership transfer outside the family
If you plan to pass your business to the next generation, you should consider a buy-sell agreement that restricts family members from transferring ownership outside the family. The agreement could be drafted in a way that enables the family to transfer ownership to parties such as private equity partners or key non-family executives (with the proviso that the executives sell the stock back to the company when they leave). It also would spell out how the stock would be bought back.
A buy-sell agreement could also stipulate that a shareholder sell his or her stock back to the company in the case of a triggering event, such as joining a competitor, dismissal from the company or disability. In some cases, this might involve a reduction in the price paid for the stock (“haircut”).
Parents who plan to transfer stock ownership to their children should discuss their intentions, including the importance of ensuring that control of the business remains in the family — before they sell or gift the shares (or their interests in an LLC or partnership).
Business families should also encourage the next generation to execute premarital (also known as prenuptial) agreements to ensure the business stays within the family. A family policy that requires premarital agreements can protect the business in the event of a divorce. It’s often best to establish such a policy well before any engagements appear imminent and to make sure everyone understands why the policy was developed. A good rule of thumb is “no surprises.”
Key planning considerations
• Talk with your family business legal counsel, but also with your estate attorney. It is important for both the professional and the personal attorneys to be on the same page. Having each of these attorneys review relevant documents, such as your buy-sell agreement, helps ensure your plans for the family business are clearly understood and all parties are working toward the same goals.
• Plan now for retirement. “It’s important to have a thoughtful plan that allows you to retire on your own terms and transfer stock to your family,” says Joel Guth, CEO and founder of Gryphon Financial Partners. In addition to helping to prevent issues down the road, “advance planning can make a significant difference in reducing unnecessary financial exposure or tax liability,” Guth says.
• Create an advisory board to help you plan for the future. Form a panel of advisers from outside your business to get a wide range of perspectives on transferring stock, developing next-generation leaders, retiring on your own terms and more. Their objective opinions can help remove the emotional aspects of tough decisions, both personal and professional.
“I formed an advisory board for the specific reason of selling my stock,” says Ken Heiberger, president of Heiberger Paving Inc. in Columbus, Ohio. “I thought about it a decade ago and wish I had done this back then. I had presented a 10-year plan to retire at age 75 to my four key people, who all raised their eyebrows. I realized I had to move my retirement target up. It takes a lot more time and a lot longer to do this than a business owner thinks.”
• Talk candidly with your next-generation members. Ask your NextGens what they really want. Are they interested in running the business? Are they hoping to retire early? Frank conversations help manage expectations and can prevent surprises or disappointments down the road.
• Make sure your buy-sell agreement reflects the goals of the owner(s). Is it your intention to keep ownership of the family business in the bloodline? Are you willing to split stock into voting and non-voting shares? Having two classes of stock could enable disengaged family members to retain ownership without a say in the direction of the company.
• Develop policies for shareholder distributions and stock redemption. Providing liquidity opportunities for shareholders who don’t work in the business reduces family conflict. Clear, written policies are essential, so there are no unrealistic expectations.
• Include non-compete clauses into your buy-sell or shareholder agreement. If a family member joins a competitor or starts a competing business, stock should be forfeited or repurchased over time, depending on the situation. Typically, instead of fair market value, the stock would be repurchased at a much lower share price.
Expect the unexpected
“It’s essential to work through these options, even though you may think some scenarios are unlikely to happen,” says J. Richard Emens, executive director of the Conway Center for Family Business and co-founder of the Emens & Wolper Law Firm. “Once you decide how you want to structure an agreement, revisit it at least every other year to ensure it reflects what’s best for you as seller and the potential stock purchasers. Family dynamics can change significantly in a relatively short period of time.”
A well-crafted buy-sell agreement can facilitate the transfer of stock ownership to the next generation without fear that the company could one day fall into the hands of an outsider. If sufficient thought has not been put into the document, there will be little protection for everything the founder worked to build.
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