Articles

What Makes Them Tick and What Makes Them Blow Up

Bruce M. Mitchell

Texas Society of CPAs (August 20, 2008)

I. IMPORTANCE OF BUY SELL AGREEMENTS.

1. Buy Sell Agreements in General. A Buy Sell Agreement is a contract among the owners of a business, including a husband and wife in a community property state such as Texas, which commonly provides for the purchase or sale of ownership in the business under certain circumstances, such as death, disability, insolvency, divorce, withdrawal or expulsion of one of the parties. Buy Sell Agreements have become increasingly sophisticated contractual instruments and often incorporate voting agreements and other contractual governance provisions, succession and family business planning provisions, income and estate tax planning concepts, and dispute resolution procedures. As private equity investors began to invest in emerging businesses, they employed Buy Sell Agreements to limit the independence of management, control future sales of equity, define an exit strategy, set financial goals, and impose a system of rewards and penalties on the founders/managers of the business for achieving or failing to achieve those goals. Once used primarily to control the ownership of stock in small closely-held or family-owned corporations, so that ownership was preserved within the group or family, Buy Sell Agreements are now used in every industry, with every form of entity, and with a level of sophistication unheard of a decade ago.

2. Buy Sell Agreements for Family Businesses. One of the primary uses of Buy Sell Agreements is to establish a succession plan for family businesses, which still account for a high proportion of all businesses in the United States. Of those family businesses which are not sold by the founders, approximately two-thirds fail in transition of management to children. One often quoted study of family businesses from 1924-1984 reveals that 80% have ceased to exist. Of the 20% which still exist, 13% are still in the family, 5% were sold to outsiders, and 2% went public and are no longer controlled by the family. M.F.R. Kets de Vries, "The Dynamics of Family Controlled Firms: The Good News and the Bad News," Organizational Dynamics, p. 59-71 (1993). There are many reasons why it is difficult to transition family businesses to successive generations, including changes in market conditions, costs, consumer tastes, personnel, etc., but the most important reason may be lack of early, effective, and properly-executed business succession planning.

3. Buy Sell Agreements for Business Succession Planning. The first step in establishing a viable business succession plan is for a business owner to consider his or her own financial situation. If the business owner does not have sufficient personal assets apart from the business to retire, then he or she cannot retire unless the business is sold. Although this appears obvious, it is not unusual for a business owner (and the owner’s children) to ignore this reality until the owner is at the brink of retirement and options are limited. Assuming that the business owner is financially prepared for retirement, the owner should develop a written business succession plan that addresses the transfer of the management, control and ownership of his or her business. This plan should address a number of important elements, including:

A. As discussed above, planning his or her retirement, including evaluating whether he or she will have sufficient income.

B. Planning for a fluid succession of management after his or her retirement;

C. Planning the ownership transfer of the business to children, employees, or third parties.

Family business owners may be reluctant to give up control during their lifetimes: often, their success in business has come from maintaining tight control over operations and management decisions. First generation entrepreuners, in particular, have difficulty giving up control. The business owner should make the critical decisions involving ownership and management well in advance of retirement, in order to address the expectations of others (family members, employees, investors, bankers, etc.), minimize management instability, and anticipate business contingencies. The business owner should also communicate his or her decision to his family and key employees.

4. Motivating the Business Owner. It is often difficult to motivate business owners to start the business succession planning process. In order to overcome this reluctance, it is important to highlight the positive things that can happen for the owner, his business and his family through good planning. Good planning starts sooner rather than later and the more time the business owner has to plan and to modify and adapt his plan, the better the plan will be for him and for the business.

5. Transfer of Ownership of Business is Distinct from Transfer of Management of Business. The decision of who will own a business is often totally separate from the decision of who will manage the business. The best manager is often an employee rather than an owner or family member. Even if the business is to be managed by family members after the owner=s retirement or death, all family members may not be involved in management and those who are may have different responsibilities and authority.

A. Transfer of Ownership. A key decision is who will succeed to the ownership of the business. The usual transferees are family members, employees or third parties through a sale transaction.

B. Lifetime Transfer of Ownership or Testamentary Transfer. If the owner=s exit strategy is to sell the business to a third party during his or her lifetime, the owner should carefully consider and plan the sale of the business, including positioning the business so as to maximize its value as of the date of the anticipated sale.

C. Testamentary Transfers. If the transfer is at death, the owner must decide whether the ownership interests in the business will be bequeathed only to active family members or equally to all family members, and whether, in the later case, the active family members should have control over the business pursuant to a Buy-Sell Agreement. If the transfer is at death, the owner should be sure that proper estate planning has been completed prior to death so as to minimize any estate taxes.

6. Estate Tax Planning. The business owner has the opportunity to achieve enormous estate tax savings with proper estate planning, using such tools as gifts or sales to shift future appreciation. Shifting a substantial part of the future growth in value can result in enormous estate tax savings.

II. COMMON TRIGGERING EVENTS.

1. Death. Most Buy-Sell Agreements are primarily intended to cover the death of an owner. A mandatory purchase requirement is often imposed, in order to generate liquidity to the deceased owner’s family. Otherwise, the deceased owner’s family may not receive any income from the business, unless they are employed by the business, the business is sold, or the business declares dividends or distributors (which is highly unlikely).

2. Disability. The Buy-Sell Agreement also often addresses disability, since if an owner is disabled he may not be receiving an income from the business. Also, the remaining owners may desire a buy-out so that they are not in the position of working in the business to support the financial needs of the disabled owner, being pressured to declare a dividend, or be subject to criticism for taking to much in compensation. Often the most difficult issue to address is how disability is determined. Common alternatives include a physician examination, reliance upon a definition of disability in a disability insurance policy, and providing for a specific number of continuous days of absence from work. If an owner is no longer able to work, his family may desire a buy-out in order to generate liquidity for support needs. The remaining owners may likewise desire a buy-out to occur in order to prevent “meddling” by the disabled owner’s spouse. The key point in a disability triggering provision is the procedure for determining when disability occurs. Various alternatives include: (1) examination by a group of physicians, (2) reliance upon a definition of disability in disability insurance policy, (3) decision solely in the discretion of the board of directors, and (4) mechanical objective standards, including items such as the specific number of days of absence from work or reduction in performance levels.

3. Termination of Employment. Termination of employment, whether by reason of retirement or otherwise, often is a triggering event under a Buy-Sell Agreement. Specifically, the Buy-Sell Agreement should address permanent retirement, voluntary termination of employment by the company and by the employee, unilateral termination by the employee, and involuntary termination of the employee with or without cause.

The remaining owners will often not want a non-employed owner to keep his interest, particularly if the non-employed owner lost his employment “for cause.” Forced sales are often the subject of disagreement, particularly if the forced sale is a result of a termination “for cause.” Often, the terminated employee/owner claims that the termination was for the purpose of acquiring his ownership at a favorable price to the acquirers. Consequently, a well-drafted Buy-Sell Agreement that is not punitive is critical in this area, where litigation is common. The recent trend in cases generally supports a forced sale upon termination of employment, assuming it does not constitute a forfeiture, E.g., Ryan v. J. Walter Thompson Co., 453 F.2d 444 (2d Cir.), cert. denied 406 U.S. 907 (1971). The sale is generally not deemed to be a forfeiture if the price was reasonable when set and if the parties acted in good faith. See In Re Estate of Borchard, 74 Misc. 2d 376, 346 N.Y.S.2d 620 (Sup. Ct. 1973). Forced sales following discharge without cause will face strict judicial scrutiny, particularly if the purchase price is below-market. See Horne v. Drachman, 247 Ga. 802, 280 S.E.2d 338 (1981); Note, Exercising Options to Repurchase Employee-Held Stock: A Question of Good Faith, 68 YALE L.J. 773 (1959).The agreement should specifically state whether purchase rights will be created upon voluntary termination of employment, involuntary discharge with cause, or involuntary discharge without cause. For each, the manner of sale should be specified. For example, the parties may want to give the corporation an option to acquire shares of a shareholder who is discharged with cause (a "bad boy" provision), but to require repurchase (giving some protection to the discharged employee) in the event of a discharge without cause. Beware that if an employee must resell his or her stock when employment terminates, and if that restriction was in effect from the time that the shareholder purchased his stock, the stock will likely be treated as section 83 property. If a shareholder enters into competition with the corporation, typically the corporation will be given an option to purchase that shareholder's shares. Typically, a right of first refusal is given first to the corporation, and if it chooses not to exercise it, to the remaining shareholders on a proportionate basis.

4. Conflicts of Interest. If an owner enters into competition with the company, files a lawsuit against the company, or otherwise is in an adversarial relationship with the company, the Buy-Sell Agreement customarily provides that the company and the other owners will be given an option to purchase the adversarial owner’s shares.

5. Rights of First Refusal. Most Buy-Sell Agreements provide for a right of first refusal in favor of the company which prohibits sales to third parties unless the interests are first offered for sale to the company and the other owners (on a proportionate basis).

6. Transfer Incident to Divorce. The owners will almost never want a divorced spouse to become an owner. The Buy-Sell Agreement commonly addresses transfers incident to divorce. Otherwise, general restrictions on sales and transfers may not apply to transfers incident to divorce in a community property state. Typically, the Buy-Sell Agreement will give the divorced owner the right to acquire any interests awarded to the divorced spouse. If that owner does not exercise his or her option, the company and remaining owners will be given the option to acquire such shares within a certain period of time from the date of the transfer. The price under a buy-sell agreement will not necessarily be recognized as the value of the owner’s interest in the company upon divorce. See Keith v. Keith, 763 S.W.2d 950 (Tex. App. - Fort Worth 1989, no writ); Geesbreght v. Geesbreght, 570 S.W.2d 427 (Tex. App. - Dallas 1983, no writ); Finn v. Finn, 658 S.W.2d 735 (Tex. App. - Dallas 1983, no writ).c.

7. Tag-Along; Drag Along Rights. The Buy-Sell Agreement may prevent a controlling owner from selling his stock to a third party unless the buyer purchases minority owners= stock at the same price (“tag along”), or may allow a controlling owner to sell his shares to the third party and compel the sale of the minority owners= stock (“drag along”). Under Texas law, controlling shareholders have fiduciary duties to minority shareholders. A tag-along provision may protect the minority shareholder by requiring the majority shareholders to sell their interests together with the minority shareholder's interest, as long as the per share purchase price is the same for the majority and minority shareholders. See Glass v. Glass, 321 S.E.2d 69 (Va. 1984) (controlling shareholder is not required to see that minority shareholders get to sell their stock at the same price and controlling shareholders may negotiate in their own interest); Treadway Cos., Inc. v. Care Corp., 638 F.2d 357 (2d Cir. 1980); Hazen, Transfer of Corporate Control and Duties of Controlling Shareholders, 125 U. PENN. L.R. 1023 (1977); Andrews, Stockholders' Right to Equal Opportunity in the Sale of Shares, 78 HARV. L. REV. 505 (1965).

8. Permitted Transfers; Gifts. Buy-Sell Agreements sometimes permit gifts to family members. This facilitates lifetime transfers for estate planning purposes. If gifts are permitted to family members, the donees are generally required to become parties to the agreement and are subject to the same limitations on transfer as the donor.

9. Use Of Independent Trustee and Enforcement of Buy-Sell Agreement. Many Buy Sell Agreements employ trustees to insure that the terms of the Buy-Sell Agreement are performed by all parties. The trustee may be designated as the beneficiary of any life insurance policies used to fund the agreement and may also hold the stock certificates executed in a form such that they may be transferred.

10. Manner Of Sale--Mandatory Or Optional. The parties must decide whether the sale upon the occurrence of each triggering event should be mandatory, optional (a put right), or optional with the entity (a call right). This decision depends upon the personal preferences of the parties, but may affect the estate tax valuation of a decedent interest. Be very careful with using mandatory purchases with cross-purchase arrangements. If, for whatever reason, the purchasing shareholders would prefer at that time to use a corporate redemption, constructive dividends may result. To avoid that potential problem, consider giving the shareholders the first right to purchase the shares, giving the corporation the second right to purchase the shares, and finally, if the corporation does not purchase the shares, requiring that the individual shareholders purchase the shares.

III. IMPORTANT CONTRACTUAL PROVISIONS

1. Written Agreement. If the Buy-Sell Agreement qualifies as a shareholder agreement under applicable law, It must be in writing signed by all shareholders and made known to the corporation. It is most commonly signed by the corporation as well as the shareholders.

2. Term. Unless the Buy-Sell Agreement provides otherwise, it is valid for ten years in the case of a corporation. It is the intent of most parties to Buy-Sell Agreements that the term of the agreement be longer than ten years, so it is important that the term be specified in the agreement.

3. Legend on Stock Certificates. The Buy-Sell Agreement must require that all stock certificates and other certificated securities have a conspicuous note that the shares are subject to the agreement. This legend must include the following:

“These shares are subject to the provisions of a shareholders= agreement that may provide for management of the corporation in a manner different that in other corporations and may subject a shareholder to certain obligations or liabilities not otherwise imposed on shareholders in other corporations.”

Any purchaser of shares who, at the time of purchase, did not have knowledge of the existence of a shareholders= agreement may be entitled to rescission of the purchase. A purchaser is deemed to have knowledge of the existence of the agreement if its existence is noted on the certificate.

4. Signatures by Spouses. If the shareholders intend that the Buy-Sell Agreement bind their spouses, the spouses should also be parties to the agreement. This is sometimes overlooked and more often simply avoided because of a reluctance to involve the spouse in Abusiness matters.@ In a community property state, unless the stock is clearly identified as separate property, the failure to include the spouse as a party can have disastrous consequences and can involve the corporation in bitter divorce proceedings. If the spouse is asked to be a party to the Buy-Sell Agreement and the spouse=s community property rights and interests become subject to the agreement, it is important to provide for the spouse to have separate legal counsel review the agreement on the spouse=s behalf. Otherwise, the spouse may claim that he or she was never advised of the contents of the agreement, was just told to “sign it,” and was fraudulently induced to sign the agreement. The professional who prepared the Buy-Sell Agreement may then be subject to a claim that the professional had a conflict of interest because the professional represented both husband and wife, was deemed to be representing the community, or did not clearly advised the spouse that the professional did not represent the spouse. Further, the professional may be subject to a claim by the shareholder or the corporation (if the professional was representing both, as often happens) for failure to address conflict of interest issues with the spouse or to insure that the Buy-Sell Agreement is specifically enforceable against the spouse.

5. Voting Agreements; Voting Trusts. Voting Agreements and Voting Trusts are sometimes included as part of a Buy-Sell Agreement. Voting Agreements and Voting Trusts are governed by a separate provision of the law from shareholder agreements and are required to have specific provisions included in them. They generally provide for the manner in which shares are to be voted under various circumstances. If they are included in a Buy-Sell Agreement, it is important that the statutory requirements be met, including a separate legend on the corporation=s stock certificates addressing them.

6. Enforceability; Arbitration. The Buy-Sell Agreement should provide for the manner in which it may be enforced. First, it is important that the Buy-Sell Agreement provide for injunctive relief in the event of any attempt to violate the terms of the Buy-Sell Agreement, such as an attempt to transfer shares in violation of share transfer restrictions. Second, it is often advisable to provide for arbitration of any dispute, in order to expedite resolution of the dispute and limit costs and because the terms of the Buy-Sell Agreement and relationship of the shareholders may be confidential.

IV. VALUATION METHODS COMMONLY USED IN BUY-SELL AGREEMENTS.

1. Importance of Agreement on a Valuation Method. The Buy-Sell Agreement should include a fair and flexible valuation method for many reasons, including the following:

A. It determines the amount to be received by a selling shareholder;

B. It prevents or resolves disputes; and

C. It is a basis for fixing an estate tax value of the stock (agreements containing mandatory buy-sell provisions do not necessarily fix the estate tax value of a deceased shareholder's shares: the price established in the agreement is only one of the valuation factors the IRS considers. Note that the estate must be obligated to sell and the price must be fixed or determinable by a formula. A purchase option by the corporation or surviving shareholders to acquire the estate's stock may also qualify as an "obligation to sell")

2. Alternative Valuation Methods.

A. Agreed/ Fixed Price. Using a fixed price is dangerous, since it will not address an increase or decrease in value after the agreement is initially executed. It is quite common for fixed price agreements to provide that the price is reset annually or on some other periodic basis; however, this rarely happens as a practical matter.

B. Book Value. Book value rarely reflects fair market value because it ignores the corporation's earning potential. Furthermore, book value does not even reflect true asset value because of depreciation.

C. Capitalization of Earnings. Another common valuation method is a capitalization of earnings. The value is obtained by multiplying the corporate earnings by a capitalization factor. Capitalization of earnings may yield unreasonable values for close corporations because expenses, such as salaries and payment of personal expenses, are often determined for personal tax planning purposes rather than business needs of the corporation.

D. Appraisal. Appraisals are generally considered the fairest method of valuation, although they are also considered the most expensive. One advantage to the appraisal method for estate tax purposes is that it allows the estate to argue for appropriate minority and marketability discounts.

E. Formula Based on Future Earnings. A formula based on expected future earnings (earn out) may be used, although it has several disadvantages, including not bringing closure on the issue, engendering disputes over how earnings are calculated (the fairness of owner compensation, etc.) and how the business was managed, and not having a valuation that can be used for estate tax purposes.

F. Push Pull Method. A push pull provision allows any shareholder to require that the other shareholder or shareholders buy his interest or sell him their interests at a price he sets. The push pull generally favors the shareholder with the deepest pocket and the shareholder who is in control of or most knowledgeable about the business.

V. COMMON FUNDING METHODS.

1. Sinking Funds. The corporation or shareholders may make a business decision to use corporate assets or to set aside a sinking fund. The sinking fund method may be required if one or more shareholders are uninsurable, or if premiums would be prohibitively excessive due to the age or health of certain shareholders. There may be limits on the ability of the corporation to use sinking funds to purchase stock in the event the corporation does not have a surplus or is insolvent.

2. Life Insurance; Redemption.

A. Use of Corporate Funds. A corporate purchase agreement permits the use of corporate funds to purchase the stock or to pay premiums on life insurance policies purchased by the corporation for the purpose of funding the agreement. The insurance premiums are nondeductible.

B. Tax Brackets. If the shareholders are in a higher federal income tax bracket than the corporation, the shareholders under a cross-purchase agreement will need more pre-tax dollars in order to pay the premiums, even if the amount of the premiums can be distributed to the shareholder as salary and be deducted by the corporation as reasonable compensation.

C. Funding by Corporation. The corporate purchase agreement keeps the funding arrangements within the control of the corporation, so that each stockholder need not rely on the other stockholders' ability to accumulate the necessary funds with which to purchase the stock or to pay insurance premiums on policies on the lives of other stockholders.

D. Dividend Treatment. Very detailed requirements must be satisfied in order for a corporate redemption to avoid being treated as taxable dividends rather than as a sale or exchange which may avoid any income tax to selling shareholders because of the step-up in basis at death. The deceased shareholder may not be able to satisfy those requirements if other family members also own stock in the corporation under the attribution rules.

E. Simplification of Insurance Program. If the corporate purchase agreement is to be funded with insurance, the corporation needs insurance policies equal only to the number of stockholders participating in the corporate purchase agreement.

F. Increase in Corporate Value. If the corporation's purchase is funded by insurance, the insurance policies constitute a corporate asset and this may increase the value of the stock owned by each stockholder for federal estate tax purposes (and may be considered in determining the purchase price for the shares of a deceased shareholder=s stock).

G. Surplus and Solvency. State law may prevent the corporation from redeeming shares because of its need to comply with surplus, solvency, and other requirements.

3. Life Insurance; Cross-Purchase Agreement.

A. Increase in Cost Basis. Under a cross-purchase agreement, each purchasing shareholder receives an increased cost basis in the shares purchased from the selling shareholder. This factor is not critical if the purchasing shareholders intend to hold their stock until their respective deaths, but it may be critical if the purchasing shareholders intend to sell their shares during their lifetimes.

B. No Corporate Creditors. Proceeds of insurance received by stockholders are removed from claims of corporation's creditors.

C. Funding Availability. Cross-purchase funding is available where a corporate deficit or inability to create a surplus precludes a redemption.

D. Insurance Premiums Are Paid with After-Tax Dollars. Shareholders pay for insurance premiums on policies to fund the cross- purchase agreement with after-tax individual rate dollars, out of their personal incomes. Assuming the shareholders' salaries can be increased and still remain reasonable compensation deductible by the corporation, the shareholders' income tax rates should be compared with that of the corporation to determine the lowest after-tax cost of paying insurance premiums.

E. Cross Purchase Plan Can Avoid Adding Values Subject to Estate Tax. Under typical buy-sell agreement provisions, at the death of a shareholder, his or her stock will be purchased by the corporation or by the surviving shareholders. This arrangement may have various substantial disadvantages. First, as each shareholder dies, increased funding will be required, because he or she will own a greater interest in the corporation. Second, each surviving shareholder would own a greater value in the corporation, and the successively greater values will be subject to estate tax.

F. Split Dollar. Split-dollar life insurance may be used under a cross-purchase agreement to assist the shareholders in acquiring insurance on the lives of the other shareholders at a lower aggregate after-tax cost than if the shareholders each merely acquired insurance on the lives of the other shareholders on their own. Under the typical split-dollar arrangement, the corporation pays the portion of the annual premium equal to the annual increase in the cash surrender value of the policy, and the employee pays the balance, if any, of each year's premium. Upon the insured's death, the corporation recovers the full amount of the premiums it paid, and the insured's beneficiary receives the balance of the proceeds.

4. ESOP=s.

A. Qualified Plans. ESOP=s are qualified retirement plans that have as their primary objective the acquisition of corporate stock to be held for providing retirement benefits for corporate employees. ESOP=s can provide a market for stock of a shareholder who wishes to sell but has not outside market and contributions to an ESOP are currently deductible.

B. Employee ownership. Eventually employees of the company will own a significant interest in the company and have substantial voting power.

VI. DISABILITY PLANNING AND SALARY CONTINUATION PLANS.

The family business owner may wish to have a formal disability plan, to facilitate the deductibility of disability payments from the business to the disabled donor. Salary continuation plans allow for disability payments while minimizing risk of being treated as unreasonable compensation. The business owner should coordinate the business=s salary continuation plan with its disability policy (for example, make sure that policy does not provide that benefits will be reduced to the extent the company has salary continuation plan; coordinate payment obligations with funding availability under policy being careful to maintain policy as “informal” funding vehicle). The present value of company's obligation to pay salary continuation right for life expectancy should be considered in valuing stock of company--which can create sizable valuation adjustment. A salary continuation plan assures cash flow for the lives of the business owner and spouse without having to retain the company's ownership to assure that result. The salary continuation right probably is included in the employee's estate if he or she predeceases the spouse. The interest should qualify for the marital deduction as long as no portion of the payments are payable to anyone other than the surviving spouse. The salary continuation right should not be included in the estate of the second spouse to die as long as the right does not pass to anyone after the deaths of both spouses. Payments must constitute reasonable compensation to be deductible to the company for federal income tax purposes. Unfunded deferred compensation is generally not taxable to the employee for federal income taxes until paid. For employment tax purposes, deferred compensation is generally taxable at the earlier of the time the services are rendered, or the right to deferred compensation becomes nonforfeitable.

VII. MISUSE OF BUY SELL AGREEMENTS

1. Treating a Buy Sell Agreement as Static. A Buy Sell Agreement is an organic document that must be reviewed and, if necessary, revised on a regular basis during the life of the business. All businesses experience change, and even the most carefully drafted Buy Sell Agreement cannot anticipate every circumstance that may arise. In particular, Buy Sell Agreements that provide for a fixed value of the business or provide that the owners will meet periodically to set a fixed value for the business are potential traps if not reviewed and updated regularly. The risk of an unintended consequence, such as an obligation to purchase another owner’s interest for far more (or less) than its actual worth, is very real if the Buy Sell Agreement is treated as a static document. In such a situation, the only thing worse than not having a Buy Sell Agreement is having a Buy Sell Agreement that causes the wrong result.

2. Leaving the Difficult Decisions for Later. During the process of preparing a Buy Sell Agreement, it is important to consider all of the issues that may arise in the course of the life of the business, and not just those that are easy to resolve or that do not require difficult decisions. If, for example, management succession is an issue for the business, a Buy Sell Agreement that skirts this issue but provides for the purchase of the majority owner’s interest upon his death or disability could postpone a decision on management succession until the person best able to make it is dead or incapacitated.

3. Ignoring Spouses or Other Invested Parties. It is common to see Buy Sell Agreements that provide for the purchase of the community property interest of an owner’s spouse that are not signed by the spouse (or that is signed by the spouse without legal representation). Too often, there is reluctance to confront the issue with the spouse directly, either because the issue of divorce is too difficult to raise with the spouse or because the valuation of the spouse’s interest is unfair. As noted above in this outline, having a Buy Sell Agreement with a punitive buy out provision that is signed by a spouse under duress is one of those situations where it is worse to have the Agreement than to not have it: it is not enforceable and shows a bad intent. Similarly, having a Buy Sell Agreement that is intended to address the interests of other parties, including children and key employees, that they are either unaware of or that they do not understand, can cause surprise, frustration and anger when finally known to them, often at a critical time for the business. A business owner should seriously consider the merits of including provisions in a Buy Sell Agreement that he or she is unwilling to discuss with his or her spouse or other invested parties during the planning stage, but is willing to have them discover when there is a crisis, such as upon the business owner’s death.

4. Not Integrating Buy Sell Agreement with Corporate Governance Documents. It is critical to have a qualified professional review the organizational and governance documents of the business as well as relevant law to determine if the intended terms of the Buy Sell Agreement are in conflict with such documents or are void or voidable under the law. For example, a Buy Sell Agreement that provides for the purchase of a physician’s interest in a professional association by a non-physician is illegal. If the Certificate of Formation of a corporation provides that the shareholders have preemptive rights, a Buy Sell Agreement that ignores this provision may be unenforceable. The Buy Sell Agreement must be integrated with the organizational and governance documents of the business.

VIII. TAX PLANNING TECHNIQUES IN CONNECTION WITH THE BUY SELL AGREEMENT.

1. How to Reduce Taxes. The business owner, perhaps more than any other type of client, may be able to achieve enormous estate tax savings with proper estate planning. Central to these savings programs would be gifts or sales or "opportunity transfers" to shift future appreciation. The REAL estate tax problem is not the large amount of estate taxes that will be payable on the current value of the business, but the estate taxes that will be payable on the future growth of the business--with compounding. For example, a business worth $1,000,000 currently that is growing at 12% per year would grow to approximately $9.6 million in 20 years. Shifting a substantial part of that future growth can result in enormous estate tax savings. GRATs may be a particularly appealing method of shifting a substantial part of the future growth without making large current taxable gifts.

Motivating business owners to start the business succession planning process can be very difficult. The most important element of all of the steps in the business succession planning process is to act.

2. Use of Estate Planning Techniques. Typical bypass trust/marital deduction planning techniques should be used (to defer estate taxes until second spouse's death and to take advantage of both spouses' exemption equivalent amounts). Leave flexibility for allocating business interests to either the bypass trust or marital deduction share. If a business interest is ultimately left to only certain family members, consider whether that bequest will be made at first spouse's death or at second spouse's death. If at first spouse's death, consider how to fund estate taxes at first spouse's death. If at second spouse's death, consider using separate QTIP trust for the business interest.

3. Valuation Discount for Partnership Interest. The IRS often argues that partnerships should be ignored for estate and gift tax valuation purposes because they have no non-tax business purpose and have no economic substance. Section 2703 provides that restrictions on the right to sell or use transferred property should be ignored for valuation purposes unless the restrictions meet a safe harbor test. The IRS has tried to argue that ''2703 may restrict the availability for discounts of limited partnership interests. Several courts have rejected the IRS's position, reasoning that the transferred interest is a partnership interest rather than partnership assets, so ''2703 should not apply to ignore inherent restrictions on the use of the underlying partnership assets. Several cases have applied section 2036 to transfers of limited partnership interests where the donor-parent retained total control of the partnership activities, and where much of the partnership income was distributed to the donor. Factors suggesting the application of section 2036 include ignoring partnership formalities, parent continuing to enjoy all the benefits of partnership assets, commingling of partnership and personal funds, depositing partnership income in personal account, using partnership checking account as personal account, using residence in partnership without paying rent, and if relationship to assets remains the same after assets are transferred to the partnership. Estate of Schauerhammer v. Comm'r, T.C. Memo 1997-242; Estate of Reichardt v. Comm'r, 114 T.C. 144 (March 1, 2000); see Estate of Strangi v. Comm'r, 115 T.C. No. 35 (Nov. 30, 2000) ('' 2036 raised too late to be considered by court but court invited scrutiny of future partnerships under '' 2036). The IRS argues that a gift arises on creation of a family limited partnership if the assets contributed by parent to the partnership exceed the value of the partnership interests received by parent. Several courts have rejected this argument.

The amounts of discounts allowed in the reported cases have varied dramatically.

IX. USE OF BUY SELL AGREEMENTS BY PRIVATE EQUITY INVESTORS.

Private equity investors employ Buy Sell Agreements for several purposes, including:

(a) limiting the independence of management;

(b) controlling future sales of equity;

(c) defining an exit strategy;

(d) setting financial goals and imposing a system of rewards and penalties for achieving or failing to achieve those goals.

1. Limiting the Independence of Management. Private equity investors routinely request to participate in major business decisions, often requiring the business to obtain their consent to any major expenditures, borrowings, contractual commitments, acquisitions, sales or restructuring as well as any issuance of additional ownership interests (although it is non uncommon for a pool of ownership interests to be set aside for employees as a performance incentive). They are often guaranteed one or more seats on the Board of Directors or Managers and may have the right to take control of the Board in the event the business does not meet predetermined performance goals. They use a Buy Sell Agreement to insure that they have these rights contractually, including in the Buy Sell Agreement voting provisions that guarantee their voting rights, rights of first refusal, anti-dilution and vesting provisions that guarantee their equity position, and "triggers" that allow them to take control should the business stumble. They will often include similar provisions in the entity's governance documents to cover all bases.

2. Controlling Future Sales of Equity. Private equity investors expect to control future sales of equity in order to minimize dilution to them. They may also wish to direct future rounds of equity financing to themselves or other private equity investors they desire to cultivate. Although it is not uncommon for a pool of ownership interests to be set aside to be used by management as a performance incentive for employees, the size of this pool is usually relatively small. Various tools are used by the private equity investors to maintain their control over future sales of equity, including employing a Buy Sell Agreement to provide for anti-dilution, preemptive rights, rights of first refusal, conversion rights (e.g., non-voting to voting or preferred to common), the issuance of options or warrants (which are evidenced by a separate instrument), and "claw back" rights.

3. Defining an Exit Strategy and Setting Financial Goals. Private equity investors commonly make an investment with a specific exit strategy in mind. The exit strategy may be to sell the business, merge, or undertake a public offering, and usually is intended to be achieved within a relatively short period of time. A Buy Sell Agreement may be used to insure that this exit strategy is implemented, by giving employee/owners specific goals to achieve and rewarding or penalizing them for achieving or not achieving those goals. Rewards may include the issuance of additional ownership, the removal of restrictions on management, conversion of debt to equity or preferred stock to common stock, and so forth. Penalties may be the loss of ownership or the right to acquire ownership, the loss of control over management decisions, or additional dilution. The Buy Sell Agreement is used as a tool to achieve the desired goals and implement the exit strategy of the private equity investor.

XII. CONCLUSION.

A well drafted and comprehensive Buy Sell Agreement is critical to any business, and should address the purchase and sale of ownership under various circumstances, business and succession planning, particularly in the context of a family owned business, retirement and estate planning, and dispute resolution procedures. It should tick like a dependable watch, be checked regularly, and be properly maintained. It should never blow up.

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Bruce M. Mitchell is the firm’s Chief Executive Officer and a Shareholder in its Corporate & Securities practice. He has been recognized as one of the Best Lawyers in America, a Texas Super Lawyer and one of San Antonio's Best Lawyers. Bruce can be reached at 210.224.2000 or bmitchell@obht.com

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