Judy and John started ABC Manufacturing Co. in 1980. At the time, they outsourced all their manufacturing needs. They had no employees and leased a small warehouse. They prepared a “buy-sell” agreement restricting the transfer of their shares to anyone else and agreed that a “fair purchase” price would be the “book value” of the business. At that time, the company was not profitable and Judy and John each borrowed the necessary capital to acquire the furniture, furnishings, and equipment of the business. They also contributed whatever funds were required for the expenses of the business.
The business took off quickly. Within five years, the sales were $5,000,000 annually. They hired a sales force and other employees. Then the business really exploded. They bought a warehouse and began to manufacture their own products. The business expanded into several locations and employed 150 employees. Revenues reached $100,000,000 per year.
Then the unexpected happened. John suffered a stroke and was unable to return to the business. According to the buy-sell agreement, he was entitled to receive one-half the “book value of the business” within one year. According to the buy-sell agreement, John’s share of the company was to be determined by taking the book value of all the assets, and deducting any debt of the business.
Unfortunately for John, ABC Manufacturing Co. was worth substantially more than “book value.” The main assets of the business were greatly depreciated for book purposes. The equipment had very little book value and the real estate had also depreciated for book purposes. The “fair market value” of the real estate was considerably higher. Based upon “book value,” John was entitled to receive approximately $5,000,000. In fact, the business had recently received an unsolicited offer for $25,000,000.
This resulted in a “good deal” for Judy. But she was lucky. What if she had suffered the stroke?
A buy-sell agreement and its valuation process should be periodically reviewed to ensure that it continues to meet the owners’ needs and expectations. Suppose the value was based on “fair market value,” which at the time was minimal and was required to be paid within one year? Now, perhaps fair market value is $25,000,000. Could the remaining owner’s business pay $12,500,000 in one year?
Events which might cause owners to review their existing buy-sell agreement include:
- Admission of other shareholders
- Use of life insurance or disability insurance to fund a purchase
- Change in tax status, such as from a C-corporation to an S-corporation or a partnership
- Changes in the business such as having new lines of business, or changing the fundamental business (for example, going from manufacturing to distribution, or to brokered sales)
- If the shareholders acquire assets for use in the business (for example, they acquire real estate and lease it to the business)
If you have any questions regarding your existing buy-sell agreement or the preparation of a new buy-sell agreement, please call Levin Ginsburg at (312) 368-0100 and ask to speak with Morris Saunders or any of our attorneys in our business transactions department.