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6 crucial questions to answer when drafting your purchase-sale agreement

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So you did it. Your lifelong dream of becoming an londonbusinessblog.com has now become a reality. You run a successful business. But have you ever thought about what happens when you’re ready to retire? Or worse, what happens in the event of an owner’s untimely death or disability? While it may seem like a distant reality, legacy planning for the business you’ve worked hard to build is an essential ingredient to running a successful business for the long haul. And that’s where a purchase-sale agreement comes in.

A purchase-sale agreement is, in its simplest definition, a contract between business owners to provide for property succession. It is a fundamental tool that allows the business to continue to thrive as the organization and its owners grow and change.

Below are some of the key questions to consider when drafting your purchase-sale agreement.

Related: What is a buy-sell agreement and why is it essential for a successful partnership?

1. How do you finance owner exits?

We often see that the departure of an owner can cause the organization to produce a large amount of capital for the owner buyout, which has the potential to cause financial stress for the company. This can often be mitigated by provisions in the purchase-sale agreement.

There are several ways to fund owner departures, including lump sum payments, installment payments, and gradual stock transfers. The transfer of this risk to an insurance company can also reduce the capital required by the company or other owners. Working with a wealth advisor and attorney can be helpful in finding a good financing option for your organization.

2. How should you structure insurance policies taken out to finance a buy-sell agreement?

While this may seem unlikely, it is important to protect your business in the event of the death or disability of an owner. The two most common forms of funded buy-sell agreements are cross-purchase and entity purchase agreements.

Usually implemented in companies with fewer owners, in a cross-purchase agreement, each owner buys an insurance policy to the other. This allows the surviving owner to fund a buyout using the insurance proceeds and increases the survivor’s tax base. This can also help reduce any subsequent taxes on a future sale of the business. In an entity purchase agreement, the company owns the insurance policies of all owners and uses the proceeds to repurchase the stock, which is then amortized.

Related: Estate Planning for an Owner Dependent Business

3. How do you replace owners who have left?

Usually, when owners start to leave, the business is still going. That is why it is important that the purchase-sale agreement lays down the conditions for the transfer of the owner.

For example, who replaces this owner? What barriers are there for the person replacing this departing owner? How does knowledge transfer work? All of these items should be described in your purchase-sale agreement to ensure that the business is not adversely affected by an owner’s departure.

4. How do you prepare for the unthinkable?

Despite the efforts many entrepreneurs have made to plan for the inevitable, you cannot predict the future. The unprecedented Covid-19 pandemic has led to significant business slowdowns and has caused many business owners to rethink their buy-sell deals. Some took advantage of the temporarily depreciated value of their companies and moved them into trusts at significantly lower valuations. Others temporarily adjusted valuation calculations and ownership statements to keep the company safe while it “weathered the storm.”

Suppose an employee wanted to buy into their company during the pandemic. Based on the existing valuation formula, the transaction would have taken place at a significantly undervalued price to the owner. A revision of the londonbusinessblog.com’s buy-sell clause in the operating agreement resulted in the addition of a section to normalize profits in times of temporary stress. We are seeing more and more agreements include these types of “failsafe” clauses to protect a business during unforeseen, usually temporary, events.

5. How will you value your business?

Your purchase-sale agreement should state how you value the business. There are a few ways one can value their business for legacy ownership or sale. Earnings before interest, taxes, depreciation and amortization (EBIDTA) multiples are one way, but they are not the only way.

From book value to enterprise value, it’s vital to use the right formula for your industry and organization. It is also quite common to include a fail-safe provision that allows an independent valuation expert to value the business. And more importantly, as the business grows, it is essential to reassess your valuation formula. It is of course not wise to constantly change your valuation formula. However, if your company is growing from 20 employees to 200, it may be time to rethink your valuation method.

Related: Exit Planning for Modern Leaders: How to Determine the Value of Your Business

6. How do you create a company that is prepared for your exit?

Once you’re ready to retire and fully enjoy the fruits of your labor, it’s important that the transition has made you — and the organization you’ve worked hard to build success. Will you stay on the board? Do you pass on the organization to family or key employees? Are you going to sell the company? These are important questions that you should take into account when drafting the old terms and conditions in your purchase-sale agreement.

Whether you’re a business owner hoping to sell quickly or someone looking to build the business for many years to come, effective succession begins before the exit. Developing a high-quality buy-sell agreement is an important part of legacy planning. By answering these questions, you can protect the integrity of the company you’ve worked hard to build.

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