The Importance of Buy-Sell Agreements

Posted by Briana Frost, Staff II, Tax Services on Jul 30, 2019

Well-crafted and legally-binding buy-sell agreements can reduce the risk of unexpected circumstances for construction companies.

Purpose of the buy-sell agreement

The purpose of a buy-sell agreement is to set up parameters for transferring ownership interest in the case of a triggering event. Triggering events most commonly refer to an owner's retirement. However, the owner's death or long-term disability, loss of licenses, bankruptcy, and/or divorce also qualify as triggering events.

Closely held construction companies are at the highest risk of difficult circumstances if a triggering event occurs because unlike public companies, there is no established market on which to sell ownership shares. 

For example, if an owner dies, his or her shares pass on to their heirs. Questions can then arise as to how much the shares are worth and to whom the heirs can then sell the shares. Buy-sell agreements aim to remove this uncertainty by stipulating, for instance, the remaining owners will buy the ownership shares as determined by the stated valuation method. The agreement can also help prevent unwanted owners from suddenly joining the business.

Avoid Valuation Issues

A sound buy-sell agreement will have a specified valuation method for appraising the departing owner's interest at the appropriate time. While choosing a method, it is essential to carefully define buyout terms and specify the financial data to be used in the agreement. Essentially, listing the required end-date for the financial statements that must be used to appraise business interests and potentially mandating a level of assurance (i.e., compilation, review, or audit) regarding those financial statements. Additionally, the buy-sell agreement needs to pinpoint a way to appraise the value of each owner's interest accurately.

Construction owners have run into issues where their buy-sell agreement states that the business is worth "four times annual earnings." But appraisers, and courts if it comes to that, might argue the definition of earnings. Some might say earnings refer to accounting net income, while others could define it as pretax earnings adjusted for items such as depreciation and amortization, interest expense, and nonrecurring items.

Choose a funding method

In many instances, owners do not have the cash readily available to buy out the departing owner's shares. Buy-sell agreements can include an insurance policy to fund the agreement.

Under a cross-purchase agreement, each owner buys life or disability insurance (or both) that covers the other owners. Should one owner die or become incapacitated, the other owners collect on their policies and use the proceeds to buy the deceased or incapacitated owner's shares. This type of policy would be helpful to business with a few owners.

Another type is a redemption agreement. Here, the company (not each owner) buys the insurance policy and acquires the deceased or incapacitated owner's shares. This approach is helpful for businesses with multiple owners because fewer policies are needed.

In some cases, companies create a hybrid buy-sell that combines aspects of the cross-purchase and redemption approaches. Agreements of this sort may stipulate that the business gets the first opportunity to redeem ownership shares. If the company is unable to buy the shares, the remaining owners are then responsible for purchasing the departing owner's interest.

Let's get started!

Creating a sound buy-sell agreement isn't easy, but it can protect your construction company from costly ownership conflicts down the road. We're happy to help you construct a buy-sell agreement for your business.

Contact our construction team today to ensure you are protecting your business from future risk.

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Topics: Construction, Buy Sell

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