The Buy/Sell Agreement: A Common Landmine in a Business Exit

Practical tips for roofing contractors considering a business sale or exploring a major life change

Over a career spanning years, I’ve met hundreds of roofing contractors across the country, consulting them on various topics, including tax, business valuation, exit planning, and risk management. They spend their entire lives building their businesses, hoping to create a valuable asset they can eventually sell or transfer to achieve a lifetime of financial independence.

Anyone who has been in those shoes can tell you it’s not as easy as it sounds. The journey from starting a business to monetizing this illiquid asset is plagued with challenges, which we call landmines. One landmine we encounter regularly starts at the beginning — an improperly crafted buy/sell agreement.

The agreement is drafted between two or more business owners to address how an ownership interest is to be liquidated in case of major life events such as death, disability, divorce, and departure (whether voluntary or involuntary).This document clarifies and simplifies the process during this challenging time in a business’s life cycle.

In many cases, these documents are drafted in an uncoordinated manner that results in the exact opposite. Here are four keys to consider when drafting your buy/sell agreement.

Valuing Your Roofing Business

You must know what you’re dealing with. When drafting provisions for valuing the business upon a triggering event, careful consideration should be given to a method for valuing the business interest. Over the years, I’ve seen provisions using flat amounts, book value, fair value, and fair market value. While these are valiant attempts at addressing the issue, each of the methods has significant consequences.

A flat amount will not consider the business's appreciating or depreciating value. We once reviewed an agreement that stated a flat $500,000 as the business's value in the case of a triggering event. However, the owners had not acknowledged that the business's value had grown to $4 million, clearly not a fair and equitable result for all parties.

Since many roofing contractors use different accounting methods for tax and financial reporting, consideration should be given to which book should be utilized. For tax purposes, the IRS can apply a significantly higher value to the business interest, accounting not only for the tangible business value but also for the intangible value trapped in the business, such as goodwill.

Fair value and fair market value are often used interchangeably, yet each method can result in significantly different values. The most significant causes for such differences are discounts for lack of marketability and control — another consideration to address in the document.

Finding Funding

The agreement should address how an interest will be redeemed in the event of a principal's death. Typically, two methods are adopted: redemption and cross-purchase. Under the redemption method, the corporation redeems the interest.

Under the cross-purchase method, each shareholder purchases the deceased shareholder’s interest. This method typically provides a more significant tax advantage to the acquiring shareholder by delivering an increased basis for that shareholder. The basis is the cost portion of the ownership interest that can be returned tax-free. Any redemption value over the basis will be subject to taxes.

If this key provision is not addressed correctly, the remaining shareholders may be subjected to substantial tax penalties when they sell their interest. Funding is typically provided by term insurance, which provides the remaining owners with a tax-free benefit that acquires the departing shareholder’s interest.

One of the pitfalls in funding the buy/sell agreement revolves around the amount of insurance to acquire, who will own the insurance, and how to fund other triggering events, such as disability.

What about a triggering event such as disability or a non-insurable event? For disability provisions, the agreement can be funded with a disability buy/out policy. This policy provides for a lump sum payout upon the disabled shareholder, who is defined as such by a physician.

In the case of a non-insurable event, the most common method for funding the departure is through the company’s cash flow. In this situation, careful provisions should be addressed in the agreement for terms such as payout timing and interest rates, if only so that the company will not be strangled by meeting the debt obligation.

Coordination is Key

Lack of coordination can also lead to unintended consequences. Ownership and the beneficiaries of insurance policies may play a significant role in the tax consequences upon a triggering event.

If you have a C-corporation, you should be mindful of who or what is insured. I've seen numerous instances where insurance proceeds, which are usually tax-free, become taxable because the C-corporation is listed as the insured beneficiary.

In a recent Supreme Court Ruling (Connelly vs. United States), the court addressed the issue of valuation when a corporate-owned life insurance policy is involved. The court stated that the death benefit should be included in the company's value, thereby increasing the shareholder's estate value. New planning strategies should be employed if your corporation owns the policy.

A buy/sell agreement should also be coordinated with other estate planning documents. We’ve seen cases where business owners have established estate planning documents, drafted buy/sell agreements, and purchased life insurance to protect the company and the family. The problem with this scenario is that none of the advising professionals communicated with each other, causing the structure to be almost catastrophic to the business and the family. These circumstances are unknown until the event occurs and the agreement is triggered.

State Your Intentions

A buy/sell agreement's fundamental purpose is to memorialize the business owner's intentions. The following are some additional points to consider when drafting a buy/sell agreement:

• Stay away from boiler-plate agreements. Each situation is unique, and each should be drafted as such.
• A buy/sell agreement encompasses many disciplines: tax, legal, valuation, insurance, estate, and financial planning. Unfortunately, the drafting and all its provisions are often left to the attorney to prepare. Allow members of your advisory team to contribute to the drafting of the agreement.
• The buy/sell agreement is a living document. Over time, the owner’s intentions change, and so should the agreement's provisions. Have a proper understanding of how the contract's provisions will work. I recommend conducting a “fire drill.” Gather your advisors and rehearse the consequences of the triggering event to determine if any unintended consequences will arise.
• If you are a single owner in a business, create a contingency plan that considers many of the provisions stated in a buy/sell agreement.

Having a properly drafted and updated agreement that makes little, if any, ambiguity will benefit all parties involved. Remember, when the agreement is triggered, circumstances are often unpleasant. In many cases, the remaining parties will negotiate, not with their long-time partner but with their spouses (and legal counsel). Remember, buy/sell agreements are intended to create clarity in times of turbulence.