Business Sale 101 – The Letter of Intent
By Wayne A. Kinkade
SAALFELD GRIGGS PC
Owners of closely held corporations with two or more shareholders should plan in advance for the retirement, death or other departures among the shareholder group. Imagine learning that a deceased shareholder has passed along his or her interest to a spouse or child that was never involved in the business. If such a transfer would not be acceptable, and purchasing the shares would be preferred, will the surviving shareholders have the money to purchase the interest of the deceased shareholder? Further, even if the owners have purchased insurance or have the cash, have they agreed to a method of valuing the shares and other terms of purchase?
One can easily imagine scenarios where the negotiation of these issues with a surviving spouse, or child would be less than pleasant. Instead, these matters are best resolved by the owners long before the occurrence of a purchase event.
TYPES OF BUY-SELL AGREEMENTS
Owners can choose from among three general types of buy-sell agreements: cross-purchase agreements, stock redemption agreements or a hybrid form of agreement that combines elements of both.
A cross-purchase agreement dictates that each shareholder will acquire an insurance policy on the other shareholders. In this situation, the purchaser is the owner and the beneficiary of one or more policies, depending on the total number of shareholders. In the event of the death of a shareholder, the surviving shareholders then use the life insurance proceeds to purchase the deceased shareholder’s stock.
One tax advantage of a cross-purchase agreement is that the surviving shareholders will have a cost basis in the stock they acquire, and the selling shareholder will have capital gains treatment from the sale. However, where a corporation has many shareholders, the ownership of multiple policies can become problematic. For example, cross-ownership can create disproportionate costs if there is a wide range of ages or differences in insurability of the shareholders. As a practical matter, cross-purchase agreements work far better where there are a limited number of shareholders who are close in age and in proportion of shares owned.
In lieu of insuring the buy-out, some corporations instead choose to extend payment over a period of several years (often up to 10 years with an option to pre-pay). In other situations, insurance is used as a down payment with the balance of the purchase price payable over a term of years.
STOCK REDEMPTION AGREEMENTS
A typical stock redemption agreement provides that the corporation will acquire insurance on the life of each shareholder. Upon the death of a shareholder, the corporation is required to purchase the stock of the deceased shareholder with the insurance proceeds.
Simplicity of administration and cost are among the advantages of stock redemption agreements. The simplification is particularly significant where there are three or more shareholders with a wide range of age, health and ownership proportion. However, unlike a cross-purchase agreement, a stock redemption will not give the surviving shareholders the benefit of a stepped-up basis upon the corporation’s purchase.
COMBINATION BUY-SELL AGREEMENTS
The most common form of buy-sell agreement actually blends corporate redemption and cross-purchase agreement elements. These agreements will often give the corporation the option to redeem the withdrawing shareholder’s shares. If the corporation is unable or unwilling to acquire all the shares, the option passes to the remaining shareholders. These agreements provide that all of the stock must be purchased by the corporation and/or the shareholders.
THE TRIGGERING EVENTS
Buy-sell agreements are designed to anticipate a number of events that may trigger a purchase. The most common triggering events are lifetime transfers, death, disability, bankruptcy, termination of employment and divorce.
Lifetime transfers: Most buy-sell agreements restrict the lifetime transfer of shares. Without such restrictions, a shareholder could sell or transfer his or her shares without the consent of the other shareholders. As a form of restriction, many buy-sell agreements also provide a “right of first refusal” (i.e., an option) to acquire the stock of a shareholder in the event the shareholder proposes to transfer stock during his or her lifetime. Basically, the corporation or remaining shareholders can prevent the acquisition of stock by the third party if they are willing to meet the offer.
Death: The agreement may provide for optional or mandatory purchase of shares upon the death of a shareholder.
Bankruptcy: The bankruptcy of a shareholder is often an event that will give the corporation and/or the other shareholders an option to purchase the stock.
Disability: The disability of a shareholder occasionally triggers a redemption or purchase of stock. Consideration must be given to determine the corporation’s, or remaining shareholders’ ability to fund such a purchase. These provisions often provide that purchase upon disability of a shareholder is optional.
Termination of Employment: These provisions may be designed to anticipate a number of situations, including the designed retirement of a shareholder upon reaching the agreed “retirement age” or years of service.
Divorce: An option to repurchase shares may be triggered by the transfer of stock caused by divorce. The agreement may provide that the selling (divorcing) shareholder may repurchase the shares of the corporation at the price at which the stock was redeemed during the divorce.
Most corporations choose one or more of the following valuation methods: agreed value, formula valuation or, appraisal.
Agreed Value: The shareholders may use a “agreed value” to be re-determined by vote of the shareholders at fixed intervals. While these agreements may create certainty if an agreement can be reached, they do have limitations. For example, it is not uncommon for shareholders to forget to revalue the corporation after the initial value is set. As a fallback, the agreement can provide that a formula or appraisal will be used if the corporation has not been recently valued.
Formula Valuation: A valuation formula may be based on book value adjusted to reflect other items of value such as goodwill, discounts of accounts receivable, work in process, fair market value of real property and equipment, accrual of expenses, and the value of life insurance owned by the corporation. Where a corporation’s income is the key asset, the valuation may be based on a capitalization of earnings.
Appraisal – The Fail Safe Approach: Appraisal may be used as the primary method of determining value or as a fallback in case the shareholders fail to agree on value. The agreement may name the appraiser or a method by which the appraiser is selected, and the minimum qualifications for selection. The agreement can either give the appraisers wide latitude in determining the method of valuation or set out guidelines on which the appraisers are to base their appraisal, such as whether to discount value for minority interests or lack of marketability.
The kinds of issues addressed in a buy-sell agreement are too often a low priority for a closely held business. That is, until a purchase event occurs. At that point, it will probably be much more difficult to negotiate price and terms.
If you wish to discuss the adoption of a buy-sell agreement, or would like more information on the topics addressed in this article, please contact any of the members of our corporate practice group.