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Succession Planning: Passing the Torch (Part 1 of 2)

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Phillip M. Perry |

Buy-Sell Agreements Smooth Family Business Transitions

NEW YORK — Most family business owners expect their thriving enterprises to transfer to the younger generation with minimal fuss and bother. Reality, though, can be far different. Absent a carefully designed plan, misunderstandings and disputes can turn any business transition—including ownership of coin laundry stores—into a costly train wreck.

Parents must analyze the skills and proclivities of their children before assigning future management roles. While such assessments can help smooth the transition, even the best of such plans needs the support of legal documents that ensure power flows to the right people and sufficient cash is available to make everything happen on cue.

SETTING TERMS

Often the most important transition document is the so-called “buy-sell agreement,” which specifies how ownership will be allocated and how the sale of shares will be funded. “A buy-sell agreement is crucial to a smooth ownership transition for a family business,” says Gregory Herman-Giddens, a board certified specialist in estate planning at the law firm of TrustCounsel, Chapel Hill, N.C. “It allows for one or more of the children who are active in the business to buy out a parent who retires or dies.”

Buy-sell agreements typically cover an array of issues that go beyond the basic transfer of ownership upon the death or retirement of the original owners. They also typically cover how ownership will transfer when one of the children exits the business, either through death, disability or even a decision to go into another line of work. Will the business itself, as an independent entity, buy up the shares of the departing individual? Or will the remaining siblings as individuals have the right to buy up the shares?

Here are some other issues that buy-sell agreements often cover:

  • What if one of the siblings desires to sell shares to an outside third party?
  • Must the siblings be offered the shares first?
  • How much time do they have to reach a decision?
  • And what if a child wishes to withdraw capital from the business? How much money can an individual owner take out, over what period of time, and how much prior notice must be given to the other owners?

These agreements also often specify the methods by which internal disputes are resolved. Some issues will lend themselves to arbitration or third-party mediation. For those which can be resolved by voting, the agreement will specify who has the power to vote and whether a simple majority or super majority is called for.

Buy-sell agreements can be real lifesavers in sticky situations. For example, they can avert unexpected shifts in power to unqualified individuals. “Often one member of the second generation receives share of ownership, then gets divorced,” notes John J. Scroggin, a partner at the estate planning law firm of Scroggin & Company, Roswell, Ga. “That individual’s former spouse now owns the equity. Unreasonable demands can follow, and that can be a thorn in the side of the family.”

The solution, says Scroggin, is to draw up clauses in buy-sell agreements that anticipate common and costly events such as divorce or unexpected death. To do this, the document should mandate a “call right” on shares that are gifted to children. The “call right” is a provision that empowers remaining family members to buy out the shares of a non-family spouse who may survive the divorce or death of a family member who was in an ownership position.

PRICING THE BUSINESS

The buy-sell agreement will usually specify the method for determining the business’ value upon the death or departure of an owner. “Commonly, the plan may call for a valuation to be done by a business valuation expert or CPA,” says Herman-Giddens. “There may also be a tie-breaker provision: Survivors who disagree over the business’ value might be able to choose their own expert, and then either those two experts agree on a third expert or the two values are averaged.”

An alternative valuation system specifies a formula to be used, such as a multiple of earnings. This can be problematic, though, since economic conditions at the time of a partner’s retirement or death may differ substantially from those at the time the plan is put together, making a pre-set formula inappropriate.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an attorney or financial adviser for advice regarding your particular situation.

Tomorrow: Tips for avoiding the hidden pitfalls of family business transitions

About the author

Phillip M. Perry

Freelance Writer

Phillip M. Perry is a freelance writer based in New York, N.Y.

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