Law News and Tips
Business Planning – Part 1
For business owners, many times their largest asset is their business. If the owner is going to plan his or her estate, they have to take the business into account. This discussion can be divided into two parts. The first part has to do with planning at the time of the formation of the business. This is where there is more than one owner, and none of the owners wants to be in business with their co-owner’s spouse. This is what we will look at in this article. The second part has to do with family planning and planning for death with wills and trusts. I’ll look at that in the next article.
BUY SELL AGREEMENTS
When two or more people go into business together, they are focusing on sales, production, costs, profits, and those kinds of things. Most of their focus is on the short term, immediate issues. That is understandable, but potentially risky.
If you’re old enough, we can trade stories about people we know who died early and many times suddenly. If you’re not old enough to know people who suddenly died, listen to your elders.
Business owners who fail to plan for a potential death run the risk of ending up in business with the co-owner’s spouse. Typically, the spouses are not involved in the business, but of course, they have a lot of advice for you after the fact. I don’t think I’ve seen a time when things have gone well. When an uninvolved spouse becomes active in the business due to a sudden death it usually means the end of the company. Planning for this eventuality is really important.
In this discussion, I am generically talking about business law and buy-sell agreements whether we are dealing with a C-corporation, an S-corporation, and LLC, or a partnership. I will simply refer to them as businesses. These ideas apply to them all.
PLANNING FOR DEATH OR DISABILITY
Although the title to this section sounds kind of ominous, this really is an important part of planning for a business. If an owner were to die suddenly, the surviving owner or owners need to have a way to buy back their deceased co-owner’s interest in the business and oftentimes to provide funding to transition to a new manager of some sort.
Typically in buy-sell agreements, the estate of a deceased owner will be required to sell his or her interest back to the business or the other owners (a discussion of which one is right for a particular business is beyond the scope of this article). The first question is value: how much is the business interest worth? Once that is determined, then the owners need to plan on how to pay the purchase price. Many times that is funded by life insurance which is the best way to handle this. If there are no life insurance proceeds or insufficient proceeds, the deficit can be paid over a designated period of time. It is important that all of this is worked out in advance. Otherwise, you can have an ownership meltdown at a time when you least need that to occur.
Disability is a little more complicated. That can be funded with a disability policy payable to the company or it can be paid out of the company profits. Also, if there is a life insurance policy with cash value, you can use the cash value to purchase the business interest. In any event, this will probably need to be paid out over time.
RIGHT OF FIRST REFUSAL
Finding a business partner in the first place is really tough. You really don’t want to be in business with just anyone. Will they be honest? Will they work hard enough? Do they know what they are doing? Another aspect of a buy-sell agreement is what is called a right of first refusal.
Since business owners don’t want to be in business with just anyone, they will usually prohibit each other from selling the business interests – whether shares of stock, units (or whatever) in an LLC, or a partnership interest – to third parties. However, the courts will not enforce just an outright prohibition. That kind of restraint on trade is not welcome in American business. The typical way to prevent such a transfer is to impose a “right-of-first-refusal.”
What happens with a right of first refusal is that when one co-owner receives an offer to buy his or her business interest, that co-owner must present that offer to the other owners and give them the right to buy the selling owner’s interest on substantially the same terms. The remaining owners can pay the purchase price over time, but they still have to buy the co-owner’s interests. The remaining owners can buy the selling owner’s interest either directly or through the business or both, depending on how you set up the buy-sell agreement. An important aspect to remember though is that no matter what, all of the selling owner’s interests that are being sought must be purchased by the remaining owners or the company. You can’t only buy a part of the interests being offered.
There is a lot involved in setting up a business when there are multiple owners, and the buy-sell agreement is an important part of it. In the next article, I will look at estate planning more specifically.
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Check out the second part of this BLOG post: Business Planning Part II. Business Planning II it's worth a few minutes to read. You may know many of the key points in these articles it's worth reviewing them, especially if you're planning
to buy or sell a business or separate from your business partner.
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