People are encouraged to start businesses. And many do. But few people think about what happens when that business comes to end. For a company owned by a single person, neglecting to think about the end is usually a manageable mistake. But for companies owned by two or more people, failing to plan is an invitation to a parade of pain when an eventual ownership change occurs.
Consider some common scenarios. Imagine that Harry and Wanda co-owned and operated a clothing store for a decade. What happens if Wanda wants to sell her stake in the business? In most cases, she’ll struggle to get paid what her stake is worth because Harry likely won’t want to buy Wanda out—at least not at a price that Wanda will want. And no one else will likely fill the gap because it’s normally difficult to sell part of a private business to an outsider.
What if Wanda gets into deep debt and her lender takes over her interest in the business? Harry may have to run the business with an owner he never asked for or anticipated.
What if Wanda develops Alzheimer’s disease? Then Harry may have to pick up Wanda’s slack, doing double duty without a concurrent increase of the profits.
What if Wanda gets divorced and her husband receives half of Wanda’s ownership in the business? Then Harry may have to own and operate a business alongside feuding divorcees. Sounds fun, doesn’t it?
What if Wanda dies and passes her ownership to her kids? Then Harry may have to run the business on his own but split the profit with the kids. Or he may have to run the business with kids, who may or may not be capable business partners.
What if Wanda’s kids sell their chunk of the business to Tommy whose vision for the business clashes with Harry’s? Then Harry needs to either sell his stake, patch things up with Tommy, or find a way to force Tommy out.
That’s a big list of problems. But they highlight a fundamental reality of businesses with more than one owner: Eventually one of the owners will stop being an owner. Maybe they’ve had enough and want to cash out. Maybe they become disabled. Or maybe they die. But one way or another, ownership of the business will change.
In planning for the inevitable, one way to minimize conflicts and maximize fairness is to create a buy-sell agreement, which is a contract between co-owners about the many ways that the partnership may come to an end. So, for example, a buy-sell agreement will spell out when an owner can sell their interests, who they can sell them to, and for how much. It will also address death, disability, divorce, and bankruptcy. In other words, a buy-sell agreement is the business equivalent of a will and a prenuptial agreement rolled into one.
What can a buy-sell agreement do for you?
First, it can guarantee a buyer when you want to sell. Having this escape clause is critical because selling a private business, especially a minority stake of a business, is hard. And even if you succeed, you will likely receive far less than you expect. The solution is a forced-buyout clause where the owners agree well in advance on the terms for one owner to buy out the other. The clause provides a ready market for selling your interest when you want to walk away.
Second, a buy-sell agreement will provide tools for current owners to maintain control of the business. This becomes important when one owner retires, gets divorced, files for bankruptcy, becomes disabled, or dies. To protect from these scenarios, generally the other owners will have the ability to buy out an owner going through one of these events.
Third, a buy-sell agreement will normally set a price for the buyout. Setting this price well beforehand eliminates a major source of litigation. The reason is that valuing a business is not an exact science. There are several reasonable ways to do so. But each approach will produce a different number. Naturally, the selling owner will prefer a valuation approach yielding the highest price whereas the buying owner will gravitate toward a valuation method producing a lower price. Such an environment is fertile ground for disagreements and, thus, lawsuits.
Fourth, a buy-sell agreement can establish how to pay for the buyout. Funding is huge because buying out a business is seldom cheap. It’s important to plan where the money is going to come from well before any of the owners want to depart. In some cases, businesses will agree to pay the departing owner in several installments. In other cases, the business creates a buy-out fund and then invests in it as the business grows. And yet another approach is for the business or each owner to take out life and disability insurance on the other owners, the proceeds of which will fund a buyout if an owner dies or becomes disabled.
Bottom line: If you co-own a business, talk with your co-owners about the scenarios discussed in this article because its much easier to solve these issues now rather than after the event has taken place.
This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.