How buy-sell agreements can resolve family business crises

A California-based family business was facing the worst crisis in its history.

Not only was its founding patriarch and CEO starting to exhibit signs of mental deterioration, but his erratic behavior was threatening the bottom line. Business decisions were being neglected. Customers were being mistreated. Top employees were headed out the door.

With the future of their company at stake, the other family members at the third-generation enterprise realized they needed to find answers to three questions: How could they convince the CEO to relinquish control before he damaged the organization irretrievably? Who would shoulder his responsibilities? And where would they find the money to purchase his corporate shares?

Buy-sell agreements

This opening story is not unusual. Family businesses everywhere can find their future imperiled when a critical shareholder can no longer exercise managerial duties. Sometimes, the cause is physical or mental disability. Other times, it is an unexpected death, resignation, termination, retirement or divorce.

Luckily, the California business was able to resolve its crisis by resorting to a tool available to family businesses everywhere. A document called a “buy-sell agreement,” drawn up years earlier, mandated the terms by which the family business stock was bought and sold and the procedures for responding to unexpected events threatening the organization’s survival. In this case, the document required performance-based assessments of the CEO’s mental competence.

“A good buy-sell agreement can shelter a family business from costly disruptions caused by material events involving its owners,” says Sam Brownell, founder of Stratus Wealth Advisors in Kensington, Maryland. “The right provisions can even keep company shares from falling into third-party hands – an event that can damage the organization’s profitability or even threaten its survival.”

Out of the blue

Family business crises are noted for their unpredictability. Here are just a few examples of some other “trigger events” that can put the bottom line at risk:

• Divorce. A family member’s divorce settlement grants the ex-spouse a batch of company shares – and a measure of unwelcome control over business decisions. The business faces a costly forced valuation and a search for cash to recapture stock.

“When a member of a family business sues for divorce, very often the spouse’s attorney will try to attach company stock,” says John R. McAlister II, vice president of The Beringer Group, a family business consultancy in Radnor, Pennsylvania. “It might also come to light that the spouse had been gifted some stock during the marriage.”

• Personal bankruptcy. A family member with a large portion of the company stock runs up excessive credit card debt. When the creditors start to eye his or her shares as part of a bankruptcy settlement, the business risks losing substantial operational control to outside parties.

• Minority shareholders. Over the years, the business has granted so many corporate shares to children and grandchildren that passive shareholders now burden operations.

“Problems can arise when people inactive in the business must be consulted to one degree or another about key management decisions,” says Richard R. Spore, an attorney with Memphis-based Bass, Berry & Sims. “Passive owners often resist shouldering the risks of change and can have conflicts of interest with those running the enterprise.”

• Underperforming personnel. A second-generation family member who recently joined the company has underperformed to the extent that he or she must be terminated. The organization risks losing control of its stock.

Valuing the stock

Any of these events – and others like them – can create hard feelings among family members. They can also disrupt business operations and even result in the loss of managerial control to third parties, unless a carefully worded buy-sell agreement sets forth appropriate procedures.

Because most solutions to ownership crises require the recapture or transfer of company stock, any successful buy-sell agreement must first specify how corporate shares will be valued. Setting a reasonable price can be difficult, though, when people on either side of the negotiating table push for assessment formulas that favor their interests. Those relinquishing stock will naturally seek the highest value possible.

The challenge can be especially great when individuals expect the value of their holdings to be equivalent to publicly traded corporations.

“Any business’s selling price will typically be less if the transition is with family members rather than third-party buyers,” Brownell says. “One reason is that external buyers who already have human resources, accounting, legal and other support departments will not need the redundant ones in a purchased enterprise. That makes the remaining parts of the business more valuable.

“In contrast, a next-generation buyer will need to retain those support departments,” Brownell adds. “The fact that there is more expense involved in keeping them reduces the value of the purchased organization.”

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