Friends and Business Partners: The Importance of Buy/Sell Agreements

Key Takeaways:

• A sudden tragedy, like the unexpected death of a business partner, can throw a thriving business into turmoil. Make sure you prepare for crisis situations.

• An outdated or improperly funded Buy/Sell Agreement can lead to significant financial and operational challenges, including potential multi-million dollar lawsuits.

• Regularly review, update, and adequately fund your Buy/Sell Agreement. When paired with the right level of life insurance, this can protect your business from financial crises and maintain operational continuity during trying times.

Imagine navigating the aftermath of a close friend's sudden passing, only to find yourself entangled in a multi-million dollar dispute with his widow. This is the cautionary tale of why every business partnership needs a rock-solid Buy/Sell Agreement.

Meet the Business Partners

Sam and his business partner, Michael, were both in their mid-40s. They were life-long friends, and had been best man in each other’s wedding. They’d also been in business together since graduating from Michigan State University. Their successful auto parts manufacturing business had grown to employ more than 100 people and generate more than $40 million in annual sales.

Then, the unthinkable happened. Michael, an avid runner, had a major heart attack while on a morning run and died.

Nobody wants to think about tragedy; but as this story demonstrates, it’s essential to avoiding a difficult and costly situation.

A Shocking Loss (and Business Crisis)

In an instant, the company was thrown into a crisis. The company not only lost the person who negotiated and secured most of the large contracts for the company, but it also lost its sales manager and emotional leader.

Michael’s wife Jenny, a homemaker caring for their three children, was panicked. She wondered how she could continue to support the family without regular income from Michael’s salary and annual distributions from the company. While they had personal savings, modest insurance policies and retirement plan assets, more than 90% of the family’s net worth was nested in their ownership of the company.

Buy/Sell Agreement

Sam and Michael had signed a buy/sell agreement early in the life of the company, but they hadn’t updated the funding of the agreement as the company grew. So, the $500,000 cross-purchase funding was far below the value of the company and could not adequately fund the purchase of Michael’s shares–now valued at approximately $18 million dollars (or three times current EBITA).

Because they were young and healthy, the two partners had put off the purchase of additional insurance and updating the cross-purchase agreement. So, income from the company provided most of the support for Sam’s family and of course Michael’s.

Additional Complications

To make matters worse, Michael had negotiated all of the biggest contracts with the major automotive companies and losing him put some of their contracts at risk. Further, two years ago, the company had borrowed $11 million dollars to purchase new machinery needed to win a contract with a high-profile customer. Michael was negotiating to extend the contract when he passed away.

Sam’s role as CFO meant he had little involvement in the company’s marketing and sales efforts, so someone would need to fill that role quickly.

When a business is thrown into crisis, complications often stack on top of each other. These complications can bring even an otherwise healthy business down.

Weighing the Options

Sam’s goal was continued operations of the company. But he also needed to consider all the options available. As he sat down to think, four potential options emerged:

1. Sell Michael’s 50% interest in the company to Jenny. Since the insurance proceeds were not enough to purchase the company shares, this was not a viable option.
2. Buy Michael’s ownership interest from Jenny. Given the current carrying debt and cash flow, it would take 10-20 years to buy out Michael’s ownership interest.
3. Find an investor to buy Jenny’s shares. This would require a significant time investment and no guaranteed outcome.
4. Sell the business to a third party. Sam did not want to sell.

Ultimately, none of these options were viable. So, Jenny and Sam agreed to continue operating the business and hire a new sales manager to assume Michael’s duties. They also agreed that Sam would become CEO.

Sudden circumstances can leave business partners with no good options.

Broken Friendship and Finances

Despite the anguish over losing his best friend, Sam kept the business running. He hired a new Sales Manager to assume Michael’s role and established a monthly distribution to Jenny based on Michael’s previous earnings–doubling the cost to the company. Over the next year, revenue fell below expenses, largely due to the loss of the contract that the company had been renegotiating. In addition, the lender to the company became concerned about the company’s changed financial condition and began to seek more restrictive lending terms. This confluence of negative events led to a projected quarterly and annual loss for the company and forced a cut to distributions–including those to Jenny. Sam tried to explain the performance of the company to Jenny, but she struggled to understand. Jenny was furious. Why would Sam do this to her? The business had provided steady income to her family for years–even through tough times. A few weeks later, Sam received a letter from Jenny’s attorney. She was suing the company for half of the last appraised value of the company. $9,000,000.

It’s a sad, but not uncommon story.

Planning ahead can help avoid stories like Sam’s.

Enter: Buy/Sell Agreements

As the business is established, many owners overlook the importance of establishing, updating and funding a buy/sell agreement. In this case, the owners had a buy/sell agreement in place. However, they funded it with Life Insurance when the company had a low valuation, and did not update the coverage as the company grew. An updated life insurance policy could have provided the funding for the company to buy out Jenny’s stock and help everyone transition. There are multiple ways to structure a buy/sell agreement. Each of them has advantages and disadvantages in tax planning, asset protection, cost and ease of management, depending on the ownership type and specific situation.

Here are a few aspects to consider:

1. Regularly update your valuation. Buy/sell agreements are often created when the company is young. As such, it’s common to see agreements with a settlement price well below the value of the company. Review and update your agreements every 2-3 years to avoid any unintentional mispricing and potential litigation from heirs.
2. Be certain the terms of sale are clear and appropriate. Most buy/sell agreements fall into one of two categories:
   • A mandatory sale or transfer of interest, which assures control stays with the surviving owner(s) and requires heirs to sell their interest to the surviving owner(s) who are required to buy it.
   • A put agreement, which allows the ownership interest to either be retained or sold by the heirs.
3.  Adequately fund the agreement. Even more common than failing to create an agreement is the issue of improper funding. Here are a few of the most common ways to fund a buy/sell agreement:
   • Set up a company-owned reserve fund and pay into it over time. This is usually the most difficult way to fund as it requires the business to set aside significant, periodic sums to distribute in the event of the untimely death or retirement of an owner.
   • Borrow the money. Some companies with superior cash flow and hard assets can borrow the money to buy out the heirs, however they are not required to sell. Also, even for solid companies with low debt, borrowing significant sums after the passing of a key owner could be challenging.
   • Make installment payments to the heirs over time. Some companies have excellent cash flow and can afford to make installment payments over time to heirs, but this should be clearly spelled out in buy/sell agreements. Also, companies often go through up and down cycles and there is more risk if the owner passes during a down cycle.
   • Life Insurance. In most cases, this is the most predictable and logical option because the proceeds are delivered at the precise moment they are needed and provided income tax free. Generally, the cost of this approach is lower versus other methods.

No matter how you ultimately decide to fund your buy/sell agreement, there is little doubt that it is better than facing down a $9,000,000 lawsuit.

Adequately updated life insurance can be a strong protection against unforeseen circumstances.

Do You Have the Right Buy/Sell Agreement in Place?

Connect with a Comerica advisor to make sure you and your business are protected in case of a situation like this. We'll work with you to review all aspects of your business and establish the right buy/sell agreement. Contact a Comerica representative today.