11/21/2007 | 3 MINUTE READ

Shareholder Agreements In Succession Planning

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Suppose you own a successful corporation with a close friend whose spouse is also involved in the business. Although you have a decent working relationship with your friend’s spouse, he or she has never demonstrated an ability to make sound business decisions. You can imagine what might happen if your friend’s stock ownership is transferred to his or her spouse in the event of your friend’s death. Would it be possible for you to successfully continue running the business with your new 50 percent partner?

Now suppose you own a minority interest in a closely held manufacturing business. The value of your interest in that business is significant, and you are reliant on that value to ultimately fund your retirement and provide an inheritance to your heirs. Since the company’s stock is not publicly traded, what happens if, upon your retirement, no one purchases your stock? Consider as well what may happen to your retirement and estate plans should you receive an offer to buy your stock at a price far below what you feel it is worth.

These scenarios occur with frequency. There is, however, a relatively easy remedy: shareholder agreements.

Shareholder agreements, also known as buy-sell agreements, are contracts drawn by legal counsel that establish a procedure for buying out an ownership interest in a closely held business, triggered by a specific event. The events that are typically considered when designing shareholder agreements are death, retirement or disability of a shareholder.

Shareholder agreements, when properly designed and implemented, benefit the business and the shareholders in many ways. Since closely held businesses are not publicly traded, shareholder agreements create a guaranteed market for that closely held stock. A valuation method or a value per share is also established. In addition, shareholder agreements lend certainty to the disposition of the business, eliminate the risk of unwanted ownership, and perhaps most importantly, create a blueprint for stock ownership that avoids a significant disruption in the management of the business during what typically is a very chaotic period.

Shareholder agreements can be structured in several ways:

  1. Stock redemption agreement: an agreement between the business and the individual owner.
  2. Cross purchase agreement: an agreement between the individual owners.
  3. Third-party buyout agreement: an agreement between the individual owners and key outside individuals.
  4. Hybrid agreement: a combination of the above.

Key to any of these types of agreements is the stock buyout price. However, that price is often difficult to determine. There are five options from which to choose, and each has its advantages and disadvantages:

  1. Fixed price per share
  2. Book value per share
  3. Capitalization of earnings
  4. Combination book value with capitalization of earnings
  5. Appraisal

If a fixed price dollar value per share is used, the established price may become quickly outdated. A mechanism should exist to use an alternative valuation method if the agreed price is not current.

The book value per share determined with reference to financial accounting records also might not be satisfactory, since it might not take into account going-concern value and asset appreciation. The book value per share method may be adjusted by segregating the items which can be separately valued.

The capitalization of earning approach averages earnings over a specified period of time, then applies a multiplier established by the anticipated return on investment. If this method is used, consider that the business may not have had a successive number of "normal" years. Also consider three factors for the capitalization method: the period over which earnings are to be computed; the appropriate capitalization rate; and the definition of "earnings."

If an appraisal approach is used, consider a mechanism for identifying the independent appraiser, determining who should participate in the election process, and deciding how frequently appraisals should be conducted. Also consider the specific valuation techniques that should be applied in determining the value of the entity or specific assets. If the agreement calls for the use of more than one appraiser, determine how disputes on value may be resolved. The appraisal approach is typically the more expensive option and a determination of who will bear the cost of the appraisal should be made prior to drafting the agreement.

Regardless of the valuation method used, the stock buyout is typically self-funded by the corporation or individuals, or may be funded with insurance proceeds.

For any business, a change in ownership is inevitable. A well-constructed shareholder agreement can limit the disruption that accompanies such a change, helping the business, its customers and employees adapt.

Reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.