Preparing for the Unknown
How does a business plan for disaster? When a shareholder involved in the operations of a closely held business dies or becomes disabled, how do the remaining shareholders minimize the disruption of regular business operations? Can the business realistically continue with a deceased shareholder’s heirs stepping in as new owners? Can the business afford to litigate the buyout of a shareholder who has decided to pursue a new opportunity? How does a business with tight cash flow come up with the money to buy out the shares of its deceased majority shareholder? How can disputes with the heirs of a deceased shareholder or between the remaining shareholders be mitigated? A closely held business will struggle to maintain its operations while addressing such issues as they arise. Advanced preparation of a written business succession plan is essential.
In general, the legal form of the company does not change the need for a written business succession plan. In the case of a corporation, the succession plan is normally incorporated into a Shareholder Agreement. The agreement is signed by the company and all shareholders and their spouses. If the business is an LLC, the provisions of the succession plan will normally be incorporated into the LLC’s operating agreement. If not in the company’s Operating Agreement, a business succession plan can also be written in a separate document, commonly known as a Buy-Sell Agreement. Although this article will primarily use the terminology applicable to corporations, the concepts are equally applicable to other business entities.
Business succession plans can address a multitude of concerns, but they should always address four key issues. First, business succession plans should define the events that can trigger the buyout of a shareholder. Second, they should state a method for valuing the corporate stock being purchased. Third, business succession plans should establish fair and equitable terms for payment of the value of the shareholder’s stock. Finally, they should identify the means by which the company or its shareholders can fund the purchase.
Events Triggering a Shareholder Buyout
A buyout provision in the Shareholder Agreement allows the shareholders to maintain control of the ownership of the company. The agreement will state which events will trigger the purchase of a shareholder’s stock and the effective date for determination of the stock’s value. Typical events that will trigger a buyout include a shareholder’s death, permanent disability, retirement, voluntary termination of employment and involuntary termination of employment for cause.
Special attention should be given to defining “permanent disability.” Permanent disability may be defined as a specific period of time during which the shareholder is unable to perform his duties. While expedient for the company and the other shareholders, this definition may be used to the detriment of the disabled shareholder. Permanent disability also may be established by a written medical opinion signed by the shareholder’s attending physician, but this is a process fraught with potential complications. In deciding on a definition, the shareholders need to weigh the importance of their individual ownership interests against the need of the company to expediently carry on its operations.
Valuation of Shareholder Stock
The Shareholder Agreement will state a formula to be used to determine the value of the departing shareholder’s stock. If this is not done, the company’s value will likely drop significantly upon the departure of a shareholder who is key to the company’s operations. Often, the value of a departing shareholder’s stock will be determined on a balance sheet basis. The company’s net equity will be multiplied by the shareholder’s percentage ownership interest in the company. Alternatively, valuations based on multipliers of earnings can be used.
The Shareholder Agreement also will state how the company’s assets will be valued. Reliance on the book values of the company’s assets often will not accurately reflect current market values. It is desirable to provide in the Shareholder Agreement for the appraisal of major company assets, particularly if the assets include substantial land and equipment which may have significantly appreciated or depreciated in value from the original purchase price. If one or more appraisals will be required to determine current asset values, the Shareholder Agreement should designate the type of appraiser to be used, such as a Member of the Appraisal Institute, to conduct an appraisal of any office, shop or other real property.
The Shareholder Agreement also should state the effective date for determination of the value of the stock. It is common to use the end of the month next preceding the date of the triggering event.
Terms For Purchase of Stock
A succession plan should provide flexibility for the company to buy out a shareholder’s stock. To enable the company to control its cash flows, it is often desirable to give the company the option to 1) make a lump sum cash payment of the value of the shareholder’s stock or 2) make deferred payments for a stated period. The maximum period for the company to make deferred payments, the interest rate on the unpaid principal balance and the frequency of payments also should be stated to define the minimum terms for a deferred payment arrangement. It is common to include either a stated interest rate or a formula to calculate the interest rate as a premium above the prime rate of interest as of the effective date.
The selection of a maximum period to make deferred payments must balance available funding against the interest of the shareholder or his or her heirs in receiving timely payment. The maximum period to complete deferred payments will require a projection of the company’s surplus annual cash flow. If the company’s cash flow has seasonal fluctuations, it may be appropriate to use annual or semi-annual payments instead of quarterly or monthly payments.
Means of Funding the Shareholder Buyout
The buyout of a shareholder can be funded using insurance, future revenue or a combination of the two. The Shareholder Agreement may provide that if available insurance is not sufficient to buy out the value of a shareholder’s stock, any unpaid balance may be paid by the company using the procedures established to make deferred payments.
If insurance is to be used to fund an immediate buyout, the company should obtain both life and disability insurance on all shareholders. If the company has a number of older shareholders, the company may want to purchase less expensive term insurance rather than whole life insurance. If insurance is to be used to fund a buyout, the company should make an annual review to confirm that existing insurance coverage is adequate to pay the estimated value of each shareholder’s stock.
If future revenue is to be used to fund a buyout, the company will give a promissory note and make the periodic payments stated in the note. The note also will provide for the payment of interest consistent with the rate of interest stated in the Shareholder Agreement. The Shareholder Agreement also may require that the company grant a security interest in designated company assets to secure payment of the note.
In deciding whether to fund a buyout from insurance or future revenue, the company must evaluate whether its cash flow will be adequate to pay the estimated values of the shareholders’ stock within the agreed period of time. For example, if the company owns tangible assets such as buildings which have substantially appreciated in value, current cash flow may not be adequate to enable to company to fund a buyout out of future revenue. If so, insurance may be a more attractive alternative to fund a buyout. If the company owns buildings with substantial equity, the company also may want to consider refinancing the buildings to generate cash to pay the buyout amount.
The company and its shareholders should prepare and sign a Shareholder Agreement that defines the events that will trigger the company’s duty to buy a shareholder’s stock and establishes a formula to determine the value of the stock. The company should have the option to make an immediate lump sum payment or deferred payments for a maximum stated period of time. The interest rate and minimum frequency of deferred payments also should be stated. The company also should determine how a shareholder buyout will be funded using future revenue, insurance or a combination thereof.
In conjunction with approval of the company’s annual financial statements, a review should be conducted to estimate the current value of each shareholder’s stock. This review should confirm whether adequate funding is available for the company either to make an immediate lump sum payment with insurance or borrowed funds or to comply with the stated maximum period for deferred payments, without impairing the company’s solvency. Such an annual review will minimize disruption of the company’s operations when the time comes to buy out a shareholder’s stock.
Glenn Nelson, J.D. is a Retired Partner with the construction law firm of Oles Morison Rinker & Baker, LLP in Seattle. His law practice included business and estate planning. He can be reached at email@example.com. Jared Stewart, J.D., C.P.A., is the Owner of Jared T. Stewart, Attorney at Law, P.S. His law practice focuses on assisting business owners with business and estate planning matters. He can be reached at firstname.lastname@example.org.