Construction Update

Agree Early on Buy-Sell Issues

Some of the emotions that go with launching a construction partnership are like those that attend a wedding — optimism and good feelings all around. There at the outset, toasting the new alliance, no one wants to dwell on the possibility that things could change.

But while a prenuptial contract is optional in a marriage, it’s not in business, where emotions take second place. Developing a clear and well-planned buy-sell agreement is a fundamental best practice for any partnership.

Companies change over time, as do individuals and their roles. And one thing is as certain as death and taxes: Everyone, eventually, will leave the business. When that happens, the difference between continuity and chaos often comes down to the buy-sell agreement, or the absence of one.

Continuity or Chaos?

Consider the effect a partner’s unexpected death would have on your business. With no signed agreement in place, you could wake up to a new business partner — the spouse of the deceased. More likely and less pleasant, imagine the spouse’s lawyer involved in your business.

Or when partner Jack announces he’s done with sheetrock and plans to paint watercolors from here on in, who’ll buy Jack’s stock? If he sells it on the market, you could soon be partnering with anybody. These unsettling scenarios — and others, including serious tax consequences and even business failure — can quickly become a reality for companies that haven’t planned adequately.

The key elements of a buy-sell agreement are its type, triggering events, valuation methodology and provisions for funding.

Types of Buy-Sell Agreements

The immediate function of most buy-sell agreements is to give the remaining owners a right of first refusal in purchasing the equity interests of a departing (or departed) co-owner. By controlling the disposition of those equity interests, the remaining owners maintain control of their company.

This purchase can be structured in one of three ways:

1. Under a cross-purchase agreement, the remaining owner or owners act individually to buy the outgoing owner’s interest.
2. Under a redemption agreement, the company itself makes the purchase.
3. Under a hybrid agreement, these forms can be combined in different ways. For example, an agreement might grant purchase options first to individual owners, and then obligate the firm to buy in case of disagreement.

Each type of agreement carries different advantages and disadvantages as regards taxes and financial reporting, and each presents different considerations in arranging funding and insurance.

Triggering Events

What events might put an owner’s shares on the market? A buy-sell agreement should define them, so that when one happens, its provisions can ensure an orderly transfer of ownership. Some include:

• Death. Make plans for your owner’s death, or you could have a spouse for a co-owner.
• Disability. Death is unambiguous, but disability can be classified in different ways. Define it carefully.
• Termination of employment for cause.
• Failure to keep up a professional license.
• Voluntary withdrawal. For whatever reason — to fund retirement, personal debts, or a new venture — your fellow partner is ready to sell his shares.

Valuation

The buy-sell agreement must provide a way of valuing the assets to be transferred. When business owners draft or revise their agreement, they have wide latitude in deciding what valuation methodology to use.

They can calculate stock value from the company’s book value. Or they can use a standard formula, or one of their own choosing. For example, they can decide that the price per share equals the average of three years’ EBITDA (earnings before interest, taxes, depreciation and amortization) divided by the number of shares outstanding.

The owners can also simply declare the value of a share, as long as it’s reasonably related to the company’s actual value. In the event of disagreement, the value could default to an agreed-upon formula.

In any case, the agreement will include a baseline purchase price and the terms of payment, as well as a formula for determining a valuation date when a triggering event makes one necessary.

Funding

How a company chooses to fund its buy-sell arrangements will reflect the philosophies of the owners.

Most choose life insurance policies on each of the owners. When insurance is used to fund a cross-purchase agreement, each owner takes out a policy on the others. In a redemption agreement, the company itself buys the policies. Premium payments are part of the monthly budget.

When an insurance payout results from death or disability — or when a cash-value policy is redeemed — some or all the proceeds are used to buy the departing owner’s stock.

Some companies borrow funds from a bank to cover a stock purchase. A company can also choose to self-fund its buy-sell arrangements. If it has the discipline for self-insurance, it can invest the money it would otherwise have paid for premiums and reap a return while having it available should a buy-sell need arise.

Finally, depending on the value of the company, owners may enjoy enough liquidity to underwrite a stock purchase with cash.

Other Considerations

Different buy-sell agreements can be in effect for different owners.

An agreement can impose “haircuts” on payments — that is, it can reduce the price paid to early-departing partners or penalize a partner who’s terminated for cause. And it can impose non-compete agreements on the departing owner.

The agreement can be structured to prohibit certain transfers. For example, it might prohibit a departing owner from transferring stock in such a way as to remove the company’s Subchapter S status.

The most solid buy-sell agreements are usually those constructed by a team that includes an attorney, CPA, insurance agent and valuation professional — and business owners who have thought through their own goals carefully. And because companies change, buy-sell agreements should be reviewed periodically.

For more information about our services to the construction industry, Contact:
Mark Lund, Parter-in-Charge of Construction Services at 713.297.6907.

The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.