In this article...
In this article we discuss business succession planning and explain how to use buy-sell agreements to plan for an owner’s retirement. We explain three different options to plan for a business owner’s retirement with buy-sell agreements, including: the company purchasing a retiring owners shares through a lump sum payment, the company purchasing a retiring owner’s shares through installment payments, and the gradual transfer of a retiring owner’s shares to the next generation.
What is a Buy-Sell Agreement?
A buy-sell agreement is a contract between business owners to provide for ownership succession should an owner wish to disassociate from the company, should the company wish to terminate an owner’s interest, or should an owner die or become disabled.
How to Plan for a Business Owner’s Retirement With Buy-Sell Agreements
Buy-sell agreements are an excellent tool to plan for an owner’s retirement. In the absence of a succession plan, the retirement of an owner can be economically painful for any remaining owners, if not impossible for the owner who seeks to retire.
In the absence of a succession plan, the owners of a company face the following problems when an owner wishes to retire:
- The retiring owner is likely to have difficulty creating a financial plan for his or her retirement years due to a lack of certainty with respect to the value he or she will receive for the sale of his or her shares in the business.
- The remaining owners may be faced with a situation in which they are required to come up with a large amount of capital on short notice in order to avoid a situation in which the retiring owner’s shares are sold to a third-party with whom they may not want to partner.
- The remaining owners may have trouble getting approved for a loan for the purchase of the retiring owner’s shares due to the imminent loss of one of the business’ principals.
- If the company is to pay a lump sum for the retiring owner’s shares, they will be doing so at a time during which the company is likely to suffer a loss of cash flow due to the loss of a key earner or organizational leader.
A well-drafted buy-sell agreement can solve these problems by providing answers to the following questions in advance:
- Will a retiring owner will be required to sell his or her shares only to the company, as opposed to a third party? (More: Stock Transfer Restrictions for Closely-Held Corporations and LLCs)
- Alternatively, will the company or remaining owners have a right of first refusal with respect to the purchase of other owners’ shares, or will the company be required to purchase the shares of a retiring owner?
- How will the price of the retiring owner’s shares be valued? (More: How to Determine a Business’ Value for Buy-Sell Agreements)
- If the company is required to purchase the shares of the retiring owner, where will the money for the purchase come from? (More: How to Fund a Buy-Sell Agreement)
- How many years will a retiring owner be required to be active in the company before having the right to exercise any retirement options (or what benchmarks will he or she be required to hit)?
- How much notice must the retiring owner provide to other owners prior to exercising any retirement options?
Owners negotiating a buy-sell agreement for the retirement of an owner should be creative to ensure that the terms of the agreement fit the specific needs of the owners in question. Below are a few alternative options for how to structure a buy-sell agreement for owner retirement.
Lump Sum Purchase of a Retiring Owner’s Shares
A buy-sell agreement may provide that when an owner reaches certain benchmarks, the other owners are required to purchase his or her shares at a certain pre-agreed value should he or she seek to retire. Similarly, the agreement may provide that if the owner wishes to sell his or her shares at any time, the company either has a right of first refusal.
The simplest option is for the company to simply be required to pay a lump sum for the shares at the time that the purchase provision is triggered. This is often attractive to the retiring owner, because he or she will have immediate access to the purchase price. However, this option may be problematic, because the owner may not have any certainty that the other owners will be able to come up with the lump sum when required.
For this reason, a lump sum payment may be coupled with a reduction of the purchase price below fair market value or a longer notice period. For example, if a retiring owner gives three years notice of his or her intention to retire, this allows for the other owners to plan for the purchase of his or her shares more comfortably than in the case of a six-month notice period.
Depending on the impact of the owner’s retirement on the company’s creditworthiness, companies that are planning for this retirement method may want to keep enough liquid funds to pay for some or all of the purchase. This has the downside of preventing the company from reinvesting this money into growth or paying it in dividends.
Funding an Owner’s Retirement Through Installment Payments
Another method to provide for an owner’s retirement is to have some or all of the purchase paid in installments over several years pursuant to a promissory note. Payment is generally guaranteed by using the company itself as collateral.
The unpaid balance of the value of the owner’s shares will typically bear interest. This method may be attractive to the retiring owner, because he or she will ultimately receive a larger sum from the company which will be paid in a fixed periodic amount over the course of many years. In this sense, it will serve a similar function to a pension.
In this scenario, the owner’s shares are generally transferred to the other owners or the company immediately, rather than over time as payments are made. This method is also usually attractive to the remaining shareholders, because the retiring owner will no longer be involved in management of the company (as in the third method we will discuss), and the remaining owners will not be required to raise a lump sum on short notice (as in the first method).
This method for retirement planning is best when the company is financially and operationally strong, because the retiring owner bears the risk that the company will default on the installment plans and go out of business.
Succession Planning through the Gradual Transfer of a Retiring Owner’s Stock
The final method we will discuss is similar to installment payments except that instead of transferring stock to the remaining owners immediately, the remaining owners will purchase the retiring owner’s stock over time and the stock will be transferred gradually as payments are made.
This solves the problem of an owner relying on the company to be well-managed by the other owners in order to continue to receive payments. However, this method may be problematic because the retiring owner may not want to continue to be involved in the company and the remaining owners may not want to continue to partner with an owner who may no longer be fully motivated. In addition, the retiring owner will have less and less control over company decisions as stock is transferred, which may lead to an awkward transition period.