"Buy-Sell Agreements Can Provide
Protection for You and Your Family"

If you own corporate stock or a membership interest in a limited liability company in a company in which you also participate in managing, what will happen to you and your family if you are permanently disabled or die? Some companies have life insurance or disability income insurance, but do either of these types of insurance policies pay you for your capital investment in your company? Or, as is usual in smaller companies, is the insurance a replacement for the lost income resulting from your death or disability?

Many companies start out with relatively little capitalization. But over even a few years, what started out as a few thousand dollars investment can grow into an asset worth many times that amount. If the disability income insurance is structured to replace your "income," if you "turn back" or sell your stock or membership interest to the other owners or the company for nothing more, you will have in essence given that valuable asset–the investment in your company--away for free! Life insurance is often mistakenly planned in a similar fashion, calculated not on the value of your portion of the asset, but on your annual and future income levels.

Without a prior agreement, there is nothing to compel the disabled owner or his or her estate to sell the shares or ownership interest back to the company. If the disabled owner or deceased owner's estate owns absolute control or working control of the company, that owner may be able to direct certain company actions even when the desire of the remaining "working" owners is to do otherwise. Even if an agreement is in place for either the remaining "working" owners or the company to acquire your equity interests, will the means to acquire your shares or membership interests be available without impairing working capital?

A properly drafted Buy-Sell Agreement can achieve the objectives for both the company and each owner. First and most importantly is creating either the obligation or option in the remaining owners or company to purchase an owner's shares or member- ship interests, generally upon death and disability. Second, such an agreement can either set the price for valuing your investment (including an updating mechanism) or a formula for calculating value at a later date. Third, a means (generally insurance) to fund the option or obligation can be evaluated and obtained. Fourth, triggering events in addition to death or disability, such as withdrawal or termination from active participation in the company's business can be addressed.

In our experience, defining the triggering events creating the obligation to purchase an ownership interest and developing a means to fund that obligation are more straightforward than agreeing upon the price to be paid for the shares or membership interest. If the co-owners are related, the valuation issue looms even larger given the federal transfer tax consequences.

The starting point for determining a valuation is the "willing buyer - willing seller" test. Briefly stated, that test defines fair market value as the price at which property changes hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having knowledge of all relevant facts. A Buy-Sell Agreement is not a substitute for replacement of income; its purpose is to provide liquidity for an asset which otherwise may be either or both difficult to sell to a third-party, or doesn't generate any income separate from employment income, while at the same time keeping the ownership of the company "closed" to outsiders. The valuation should be objective, establishing a price which any party to the Agreement should be comfortable to both pay and be paid. Only when that equilibrium is reached can it be said that a formulated value has been agreed upon.

There exists three principal business valuation methodologies: net asset (i.e. book) value; market value; and earnings capacity. While a single method may be used to determine the valuation of a company and the ownership interests, it is not uncommon to have a formula consisting of weighted averages of two or more methods, or components of each method in a tailored valuation formula.

In the context of related family members being parties to a Buy-Sell Agreement, the Internal Revenue Service has offered guidance on the valuation of privately held business interests. In an older Revenue Ruling, the IRS listed eight factors to be weighed in determining whether the valuation, in the application of the estate tax, is a fair value. Those eight factors are:

(1) the nature of the business and the history of the enterprise

(2) the economic outlook in general and the condition and outlook of the specific industry in particular;

(3) the book value of the stock and the financial conditions of the business;

(4) the company's earning capacity;

(5) the company's dividend-paying capacity;

(6) whether the enterprise has goodwill or other intangible value;

(7) sales of the stock and the size of the block of stock to be valued; and

(8) the market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded.

Buy-Sell Agreements protect both owners and the company (and thus the remaining owners) by providing a framework for the orderly transfer of ownership and control in the event of certain contingencies. A valuable asset to any closely held company, a Buy-Sell Agreement's value to an individual owner is often overlooked. Next to one's home, often the largest investment one makes is in their company. Buy-Sell Agreements allow an owner to get that investment (and its appreciation) back, thus providing more than just replacement of "lost income."