What You Need To Know About Buy-Sell Agreements

October 2, 2017 12:03 PM
 
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If you are in business with someone, you should know how to exit the arrangement. A buy-sell agreement is a legally binding document between co-owners of a business that spells out how a business should be transferred if a co-owner leaves the business willingly or is terminated.

“Planning on the front end is the best recipe for avoiding litigation or hard feelings down the road,” says Paul P. Morf, attorney with Simmons Perrine Moyer Bergman in Cedar Rapids, Iowa. “I believe every entity owned by two or more people should have such an ownership agreement.” 

Why should farmers have a buy-sell agreement?

“A buy-sell agreement is a no-brainer when unrelated parties are in business together or when brothers or cousins farm together,” explains Polly Dobbs, owner of Dobbs Legal Group in Peru, Ind. “Upon certain triggers, an owner may be contractually obligated to sell his or her interests to the company or other owners. The company or other owners may have the option to buy those interests or be required to do so.” A buy-sell agreement defines which people or trusts can buy or inherit shares of a business. “This not only protects the family from unwanted partners, it avoids disputes over issues such as an owner’s spouse inheriting shares,” Morf says. “Failing to create an exit plan can lock families together in a mechanism that may have worked for three brothers but works poorly for 25 second-cousins two generations later.”

How do you determine the purchase price for assets?

A farm owned by an entity will need two values: appraisal of the farmland, improvements, equipment and assets; and a business valuation of an interest in the entity with appropriate discounts. The purchase price can be based on an agreement by the owners, a formula or an appraisal, Dobbs says. Discounts can be used for family members. “You can apply a discount of 30% to 45% to non-controlling interests in family corporations and LLCs to reflect lack of control or marketability and other discounts,” Morf says.

What events trigger the use of a buy-sell agreement?

Events include death, disability, retirement, divorce, bankruptcy, attempts to sell interest in the company to outsiders, competition against the business or involuntary termination of employment, Dobbs says. In drafting your agreement, you spell out the events that prompt the document to come into play.

How do you define a buy-sell agreement for a multifamily operation?

If three brothers plan to transfer shares to each of their own children, for example, Morf suggests treating the three families as separate ownership groups. Suppose David has three children: Abe, Bill and Cooper. Cooper dies without children, and his will states shares should be left to his spouse. The agreement can give Abe and Bill the first right to buy those shares from Cooper’s spouse, before they are offered to David’s brothers or his brothers’ children.

What are common mistakes farmers make with buy-sell agreements?

“An old or outdated buy-sell can be worse than no agreement at all,” Dobbs says. If you are updating an old version or creating a new one, she suggests having your attorney and CPA walk you through the agreement and the formula for valuing assets, liabilities and ownership interests. “Then have everyone sign off on it,” she encourages. That way, everyone knows what his or her interest is worth. The valuation process is critical, Morf agrees. “Many old agreements use ‘book value’ or ‘agreed value’ to determine price, and it is rare book value is reflective of actual value or that parties regularly update their ‘agreed value,’” he says. “Those issues have led to numerous litigated cases involving farm agreements. Also, the IRS is generally not bound by the value specified in a buy-sell agreement.”

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