Why You Should Have a Buy-Sell Agreement

buy-sell

A chief concern of multiple owners of a closely held business, including a CrossFit Box, is what would happen to the business if one of the owners could no longer continue. Surviving owners generally want to ensure a continuity of ownership and management without having the departing owner’s successor thrust upon them. Nor do they want to unduly compromise the liquidity needs of the business by funding a significant buyout. Disabled or deceased owners would want their families compensated fairly for their share of the business.

The answer to these situations is the buy-sell agreement: a contractual agreement between the owners of the Box that spells out in detail how the business will be handled in the event an owner becomes deceased, disabled or simply no longer wants to be an owner. More specifically, a properly drafted buy-sell agreement can achieve all of these goals by:

  • Providing that upon the occurrence of a specified “triggering event,” owners are guaranteed that their interest in the business will be purchased.
  • Providing that the owner’s interest must be sold to the company, the remaining owners or a combination of the two.
  • Providing a mechanism whereby the purchase price may be determined by market conditions in existence upon the occurrence of the event.
  • Providing a funding source, primarily through insurance policies, so that the liquidity needs of the business or its owners will not be onerous.

Triggering Events

An integral part of any buy-sell agreement is to specify what type of situations will cause a mandatory or optional buyout of an owner’s interest by the other owners or the entity itself. The most common of these triggering events are described below:

Death or disability. This event is almost universally provided for in the buy-sell agreement. Terms of this buyout will include the determination of disability, the time for payment to the owner or the owner’s estate, whether the entity or the remaining owners of the Box have the obligation to purchase the interest, and whether a funding mechanism, such as life or disability insurance, should be maintained by the entity or the owners personally.

Desire to sell the interest to a third party. The agreement should provide that the terms of the potential sale of a Box owner’s interest be presented to the other owners, and that they be given the option of:

  • Matching the offer made by the outsider.
  • Purchasing the shares in accordance with the valuation method and payment terms provided for within the agreement.
  • Having the entity repurchase the shares issued in accordance with the valuation method provided for within the agreement.
  • Allowing the sale to be effectuated to the third party.

Retirement of an owner. While a sale to a third party would provide the other owners an optional right to purchase the selling owner’s interest, an owner’s retirement will generally trigger a mandatory buyout. Of course, the conditions under which an owner may have the right to retire so that the remaining owners, or the entity, would be compelled to buy that owner out are often a point of negotiation. Once again, valuation methods and payment terms will be important issues, because there are no outside funding mechanisms, such as life or disability insurance, available to bear the cost.

Owner’s divorce or bankruptcy. Either of these events can subject the business to interference from outsiders. To prevent this, the other owners should have the option to compel the affected owner to sell his shares to the remaining owners or the entity itself, in accordance with the payment terms and valuation methods.

Valuation Methods

The goal of a valuation method is to best approximate the business’s actual fair market valueFair market value has been defined as the price at which property passes between a willing buyer and seller, neither under any compulsion to buy or sell, and both with knowledge of all relevant facts. Of course, where less than the entire ownership interest is being acquired, there might be discounts to reflect the lack of control or lack of marketability. Some of the more common business valuation methods are summarized below:

Book value. This method, also known as the net asset value method, is based on the net worth (assets, liabilities) of a business on a company’s books and records for accounting purposes. While this method is easy and relatively inexpensive to ascertain, book values are based on historical-cost principles, which frequently become unrealistic over time, especially for assets such as real estate, patents and goodwill, and therefore this method can produce a depressed sales price for a seller.

Capitalization of earnings. This method attempts to value a business by estimating an acceptable rate of return on a purchaser’s investment in light of the risk associated with the particular business, and then applying such a rate of return to the anticipated earnings stream of the business, based on its average net earnings over the last few years. Any potential buyers would obviously be looking at a rate of return on their investment well in excess of the rate of return on a much safer alternative, such as a certificate of deposit or a blue-chip stock. Rates of 20 percent or more are not uncommon for small, closely-held businesses.

Discounted cash flow. This method seeks to adjust earnings for any noncash expenses (e.g. depreciation, amortization, gains and losses), and subtract a reasonable amount for future capital expenditures (e.g., equipment replacement) and liability payments to project the future net cash flow over a period of time. Then, using present-value concepts, based on an estimated discount rate over the term, an acceptable purchase price is determined for that future cash flow

Security Against Unforeseen Events

Executing a carefully planned buy-sell agreement can assure owners of a CrossFit Box that their interest in the business they built is secure regardless of any unforeseen circumstances. In many cases this can be accomplished without putting excessive strain on the business’s cash flow, ensuring the business and its remaining owners continue to succeed. Since this document has many legal ramifications, it should be developed and drafted by an attorney. Generally the average legal costs of implementing a buy-sell agreement is $1,500 to $2,500.

 

NOTE: This literature has been developed by Del Duca Law Offices to provide general information about the topic discussed. The information discussed is not intended to create, and do not create, an attorney-client relationship or representation regarding any potential engagement. Readers should not act upon these materials without seeking professional counsel.

Ron Del Duca
Ron Del Duca is a business lawyer with over 30 years’ experience and is also the owner of CrossFit Mayview in Pittsburgh, Pennsylvania. He can be contacted at 412.722.2552 or ron@delducalawoffices.com.