The Impact of an Up-to-Date Buy-Sell Agreement
Regularly updating your Company’s buy-sell agreement is an essential way to plan for unexpected business events. Buy-sell agreements are binding contracts that outline when owners can sell their interest, who can buy the interest, how the business will be valued, along with numerous other specifications. To read more about the importance of an up-to-date agreement, see FAZ Forensics article published on November 2, 2023 via the following link: FAZ Forensics: The Importance of an Up-to-Date Buy-Sell Agreement.
Company shareholders[1] operating without an up-to-date buy-sell agreement expose themselves to unnecessary financial risk. These agreements help shareholders remain shielded from overpaying for a partners’ interest, receiving under market value payment for their own interest, allowing their interest to be at-risk for another partners’ bankruptcy, and much more. The below scenario puts the financial risk into perspective:
On January 1, 2010, Partners X, Y, and Z formed ABC Rentals, LLC as equal partners. ABC Rentals, LLC operates as a real estate holding company for the residential properties purchased, improved/refinished, and rented. A fixed price buy-sell agreement was created and dated January 15, 2010.
Between 2010 and 2015, ABC Rentals, LLC purchased and refinished only 3 properties, recovering from poor market conditions and low cash flow. Assuming the business value increased since inception, the Partners decided to update their fixed price buy-sell agreement as of December 31, 2015. The valuation of ABC Rentals, LLC was determined to be $450,000.
As the market began to increase in 2015, the Partners decided to increase their portfolio property count and expand the business operations. Within the next six years to 2021, ABC Rentals, LLC purchased, renovated, and occupied 15 additional rental properties, all of which remain in good standing.
In 2021, Partner Y unexpectedly passed away.
As Partners X and Z gathered necessary information regarding Partner Y’s ownership value in ABC Rentals, LLC, they recovered the Company’s buy-sell agreement, dated December 31, 2015. According to the buy-sell agreement, the Company’s value remains $450,000. Partner Y’s family is entitled to $150,000 (one-third ownership interest).
Given the Company increased their property portfolio from three residential rental properties to eighteen with high profitability and cash flow margins, along with the inflated residential real estate market impacts, the Company would likely be worth closer to $3 million. If an updated buy-sell agreement was completed closer to the present day, Partner Y’s family would be entitled to nearly $1 million.
In a time of heartbreak and need, Partner Y’s family faces a loss of $850,000 for his/her ownership interest in ABC Rentals, LLC.
Companies inevitably become more or less valuable as operations evolve over time. To protect yourself, your business partners, and your family from paying or receiving an amount inequivalent to the fair market value, investing time into regularly updating your buy-sell agreement is crucial. As a shareholder – if your business partners and family members are important to you, your buy-sell agreement should be, too.
[1] Note: The term “shareholders” is used to represent shareholders, stockholders, partners, and owners.