This column is a continuation of my discussion on company planning. Not long ago I had a call from a woman whose husband had died; she wanted help in selling his business. The problem was that the business stopped operating the day he died-and its value was greatly reduced that day. The owner did not have a plan in place with another licensed surveyor who could take over and continue the business until it could be sold. The sad truth is that the only value left in his business was possibly in the records of his client base. It did not have to be this way. Having a plan could have salvaged most of the value of his business and continued the employment of the workers.
One of the best tools to protect yourself, your family and business is to have a buy/sell agreement in place. This agreement addresses everything from what will happen in the event of the owner's death to phasing additional stockholders in and out. This buy/sell agreement also establishes a yearly stock value, which is a good indicator of the health of the company. While this column discusses some of the basics of buy/sell agreements, it is only the tip of the iceberg. To set up a buy/sell agreement, you will need to utilize the professional services of others, including attorneys and financial planners.
Defining TermsTo get started in our discussion of this agreement, we need to define a few terms.Buy/sell agreements- the legal document between a corporation and its shareholders that establishes the value and conditions for selling or buying of shares of corporate stock between employees and the corporation (or LLC or partnership), or between outside investors and the corporation.
Fair market value - the price at which a corporation would change hands between a willing buyer and willing seller based on both parties having reasonable knowledge of all the facts connected with the sale.
Book value - the value given as stockholders' equity at the end of each fiscal year based on the balance sheet of the corporation (determined in accordance with generally accepted accounting principles).
Types of Agreement
Redemption - an agreement where the corporation itself must (or may) purchase all or part of the interest of the shareholders upon the occurrence of special designated events.
Cross-purchase - an agreement among shareholders under which they must (or may) purchase any or all the stock interest of another stockholder upon the occurrence of special designated events.
Combination - an agreement whereby existing stockholders purchase part of a stockholder's shares and the corporation purchases the remainder.
Outside-purchase - an agreement with non-employees to purchase the stock of the corporation upon the occurrence of special designated events.
Types of Stock
Common stock - a class of voting stock with value established by dividing the total number of issued shares into the value of the corporation. This value is subject to annual fluctuation that reflects the financial position of the company.
Preferred stock - a stock guaranteed priority by a corporation's charter over its common stock in the payment of dividends and in the distribution of assets. The return on preferred stock can be an amount set by the board of directors at an annual meeting. In order to own this type of stock, employees may be required to be registered in a corporation providing professional services. Sometimes this type of stock ownership is only offered to officers in the corporation.
Non-voting - common stock sometimes offered for non-registered employees to enjoy all the benefits of common stock, but is non-voting.
Setting Up an AgreementNow let's talk about how a buy/sell agreement may serve you as the company owner, along with your employees and family. Designing a good buy/sell is a very complex issue and requires both an attorney and accountant. Many surveying and engineering companies operate as closely held corporations. This means that the stock is controlled by a very small group of people, in many cases a family. The value of this type of corporation is carefully controlled by the IRS to protect minority stockholders in closely held corporations where the stock is not public.
Employee stock ownership plans (ESOPs) are subject to Internal Revenue Code and U.S. Treasury and Labor Department regulations promulgated under the Employee Retirement Income Security Act (ERISA) of 1974 and as subsequently modified. ERISA Sec. 3(18) requires that adequate consideration (fair market value) be received for assets purchased by ESOPs and others, and be conducted in good faith.
Instead of specific guidelines, the IRS has taken the position that Revenue Ruling 59-60 (March 1959), as subsequently modified by Revenue Rules 65-195, is an appropriate standard for use in determining the fair market value of closely held corporation securities. This ruling, as modified, also relates to valuation for gift and estate tax purposes.
If an owner (or owners) of a company wants to retire or transition out of a company, planning needs to take place years before the event. I know of one case when an owner wanted to retire, and he called two junior engineers into his office. He told them he wanted to sell them his ownership for a very large sum of money-within the following week. The employees, who did not have access to large amounts of money, left the company and opened their own office two blocks down the street, taking all their clients from the man's business with them. This left the original owner with very little to sell. Realizing maximum dollars for your company's value takes planning and a good buy/sell agreement with either existing employees or an outside interest.
A very important part of your buy/sell agreement is a section sometimes referred to as "lifetime restrictions." These restrictions address what is to happen when stockholders leave employment with the company. Most closely held companies do not want to have stockholders who are not full-time employees of the company. These restrictions require the employees to dispose of their stock back to the corporation or other stockholders if they leave the company. This sale falls into two categories, voluntary transfers and involuntary transfers. A voluntary transfer is when a person leaves the company for retirement or other employment. An involuntary transfer may address the permanent disability of a shareholder unable to perform tasks required of an employee, or similar issues that arise.
Many buy/sell agreements have a special section dealing with the death of a stockholder. Closely held corporations require that outstanding stock be returned to the corporation upon the death of the stockholder. The money to purchase the stock from family members in most cases is funded by insurance policies held by the corporation on the stockholder's life. The stock is then returned to the corporation as unissued shares.
Many company owners start out with good intentions to put a buy/sell agreement in place with employees or outside interests. The process, however, drags on for years without being completed. Beware of the person who never completes the process. In some cases, the person is in denial that one day he or she is going to retire or have to give up control of the company. Sometimes the owner is waiting for a better offer from an outside interest. If this process takes more than a year, realize that it most likely is not going to happen and move on to other employment.
Remember my opening story about the surveyor who died and left his wife the responsibility of disposing of his company. I repeat: it did not have to be this way. My understanding was this was not a sudden death; this surveyor could have worked out a buy/sell agreement with another company before his death. This would have relieved his wife of this burden and maybe realized a better financial return from the value of the company.
In my next column I will continue my discussion on company planning with a look at one- and five-year business plans.