The last two weeks, we have been discussing the setting up of your business and protecting yourself from business creditors. One of the most important items that is often overlooked when setting up a business is getting out of the business. This is called an exit strategy.
Your business or practice is going strong. You are making a comfortable living. When was the last time that you thought about what would happen to the business when you are no longer running it. This could be in the near future, such as with an unexpected disability or death. It could be many, many years down the road when you are considering retirement.
Do you have family or key employees who can run the company if you cannot, at least until it can be sold or closed down? Are you grooming someone to take over and buy the company? Have you considered or made arrangements for your successors to finance the purchase of the company?
Do not wait until you are in your seventies and your kids are in their fifties to sell them the business. I have seen this happen. At that stage in their lives, the kids may not want to go into debt for ten or more years to buy the business and when it’s finally paid off, they have to find a buyer for the company before they can retire. They are happy to work for the company for another ten or so years until their retirement, but not want have to buy the company. You then have to find a buyer and worry about how long the buyer will keep your kids employed.
When you have co-owners in the business, the exit strategy should be documented in a comprehensive buy/sell agreement. The buy/sell agreement details the procedures to follow when co-owners no longer will be working together, be it through retirement, death, disability or otherwise.
The buy/sell agreement should include all of the events which could trigger the buy/sell transaction. Some events which trigger the buy/selltransaction are when one of the co-owners retires, becomes disabled, no longer works full-time, dies or wants out. The trigger should include situations when one owner no longer wants to work with another owner because of a disagreement or the owners just can no longer get along. Other reasons that could trigger the provisions of a buy/sell agreement are owner gets divorced, becomes insolvent, goes bankrupt, gets sued or fails to make a capital contribution.
It should be clear in your buy/sell agreement at which price the selling owner will sell the ownership interest in the business. You may want to use a stated value to which the co-owners agree on an annual basis. I do not recommend this. I have seen numerous businesses over the last 30 years with this type of sales pricing, and only one company has ever kept it up to date. If it is not kept up to date, it could be as if you had not set a price at all, and the parties disagree as to the company value.
When parties disagree on value, it inevitably ends up that the selling owner thinks the company is worth more than the buying owner thinks its worth. I had one case in which there were three owners of a company. I had encouraged them for years to have a buy/sell agreement, but they did not want to spend the money for the legal fees to complete it. The selling owner wanted $1 million for his share. The buying owners believed the whole company was only worth $1 million, or $333,333 per owner. They ended up spending over $20,000 for a business appraisal that that was grudgingly acceptable to all parties. The cost of the buy/sell agreement would only have been a fraction of the business appraisal cost.
I had another case in which two owners were splitting up a business because they could no longer get along. They agreed on the distribution of the real estate, machinery and equipment, supplies and inventory. All that was left was a bank account with $60,000 to which both owners believed they were entitled. Between legal fees of $25,000 each and court appointed receiver fees of $15,000, not only did neither party net any of the bank account in dispute, they each had to spend additional amounts out of their own pockets.
Setting up a mechanism for determining the sales price or the orderly distribution of assets is important. A formula value based upon sales, income or other factors is another option to determine the sales price for the ownership interest. Book value of assets is occasionally used for business sales upon certain triggering events. You may prefer that the selling price be determined by an appraiser or appraisers. Or there could be an industry specific formula, such as those that may be agreed to in a franchise agreement.
I had one case with a retail store for which the two owners did have a buy/sell agreement. The real estate would be appraised, the inventory would be transferred at purchase price and the fixtures would be transferred at depreciated book value. The two owners also had regular contact with their local banker. When one owner wanted to retire, they had the real estate appraised, did an inventory and accounting. and half of the company was sold to the remaining owner, who financed the purchase with the local bank. No muss, no fuss, because they had clear instructions in the buy/sell agreement.
When you have a buy/sell agreement, it is important that the buyer be able to fund the purchase. This is frequently accomplished with seller financing. Life insurance is sometimes used, especially after a death of an owner. In other instances, bank financing may be able to be utilized. A buy/sell agreement is very little protection if you are unable to finance the purchase.
The buy/sell agreement should document who is going to purchase the ownership interest of the seller, and whether the purchase is mandatory or just an option. The company can be the buyer or the other owners can be the buyers. You can set it up so that he company first has the option to buy, then the other owners. Or it can be the other owners first have an option, then the company.
You may be tempted to just put a few pages of buy/sell provisions into your corporate bylaws or limited liability company (LLC) operating agreement thinking you have adequate buy/sell protection. Unfortunately these limited provisions do not cover all of the situations that could arise between business owners. Inevitably, you end up in a situation not contemplated in those few pages. I have seen this happen time and time again. And guess where you end up? Usually in court.
A comprehensive buy/sell agreement is often longer than the corporate bylaws or LLC operating agreement themselves. The legal fees to prepare such a comprehensive buy/sell agreement usually are more than to set up the corporation or LLC in the first place.
If you have co-owners in your business, the initial cost should not stop you from obtaining a comprehensive buy/sell agreement. I regularly see situations where co-owners did not enter into a comprehensive buy/sell agreement when the business was started. Then years later one of the owners wants out, or one or more of the owners want another owner out
Then it is oftentimes too late. At that point, you have nothing documented to govern the buy-out. And since the owners cannot agree, you usually have only one option, court proceedings at a cost of tens of thousands of dollars in legal fees for each party. The cost of these court proceedings are substantially more than what it would have cost to set up a proper buy/sell agreement at the outset.
Do you and your co-owners a favor, enter into a comprehensive buy/sell agreement when you start your business. You will save yourselves a lot of headaches later.
By Matthew M. Wallace, CPA, JD
Published edited October 30, 2016 in The Times Herald newspaper, Port Huron, Michigan as: Business exit strategies are critical