Ownership transition is common. A buy-sell agreement can help smooth the way. Our team details the benefits, risks, and approaches to choose from.
In the hectic, day-to-day management of a dealership, it’s easy to push off future planning. However, it’s critical for multiple-owner dealerships to establish a buy-sell agreement and review it regularly – every year or two, and whenever a relevant change is required (for example, updating the valuation method, aligning with the estate plan, or making revisions to maintain compliance).
An owners’ buy-sell agreement is a legally binding agreement by and between dealership owners that governs the situation if a co-owner dies or leaves the dealership. Having such an agreement in place before facing a life- and dealership-changing event is a great way to effectively plan without the emotions and needs that can arise from these events. Here are the benefits of these agreements and some ideas for how they should be structured.
Know the benefits of a buy-sell agreement
Buy-sell agreements are incredibly beneficial because they can:
- Provide a smooth transition and continuity of management and ownership
- Create an instant market for a business interest that might not otherwise be saleable
- Offer tax advantages
- Provide liquidity for estate taxes
- Deter disputes about succession and value with the exiting owner’s family
- Contribute to owners’ peace of mind from knowing that the dealership is in capable hands should they no longer be able or want to manage it
Understand the risks of delaying a buy-sell agreement
Some owners might believe that buy-sell agreements are not necessary if they intend for their estates to receive their dealership interests. However, a variety of complications can arise along the way, including:
- A spouse or beneficiary who dies first
- A surviving co-owner who does not want to be in partnership with heirs
- Surviving beneficiaries who might need liquidity more than a business interest in a dealership
- A potential family conflict because the asset in the estate is not liquid
- Surviving beneficiaries who might not know anything about or be interested in the dealership
Decide which type of buy-sell agreement is right for your needs
Most dealership owners implement one of two types of buy-sell agreements: a cross-purchase agreement or an entity-purchase agreement.
- In a cross-purchase agreement, the remaining owners buy out the interest of the withdrawing owner.
- In an entity-purchase agreement, the dealership buys out the interest of the withdrawing owner.
- Some choose to use a hybrid approach, where the agreement is structured as a cross-purchase agreement but allows for an entity redemption should the surviving owner elect not to purchase the ownership interest from the departing owner.
Determine a valuation mechanism that works for your dealership
After deciding on the type of agreement, the next step is determining the valuation mechanism. This determination can be difficult, but establishing the worth of the dealership is essential for the agreement’s success. For example, surviving owners want to be fair to the decedent owners’ beneficiaries, but they do not want to overpay. At the same time, owners want their families to receive the maximum amount possible for their dealership interests.
Selecting a method for determining fair market value of an ongoing dealership should be done carefully and with professional advice. Dealers should consider basing the buy-sell agreement on a formal business valuation, because the Internal Revenue Service can impose penalties for understating the value of an asset for estate tax purposes. The most common valuation mechanisms include:
- Fixed-price arrangements
- Fixed-price arrangements set the price of future purchases at a specific dollar amount by stating a value for the dealership. All owners agree to a buy-sell price.
- However, that fixed price could become outdated due to the constant evolution of a dealership, the owners seldom knowing the true value of the dealership and setting unrealistic prices, and different triggering events that might cause different values (such as the death, retirement, or removal of an owner).
- Formula arrangements
- Formula arrangements establish value by providing specific calculations to determine the buy-sell price. The formula is based on a multiple of the company’s operating income.
- One downside for this type of arrangement is that the selected formula could provide unreasonable or unrealistic valuations depending on the timing of the triggering event and the specific circumstances affecting the business when the valuation is needed.
- Business valuation arrangements
- Business valuation arrangements define the valuation process and outline how future transactions will be priced, and they usually require using one or more business appraisers to help determine that price. In this method, all parties agree on the process, and owners obtain a qualified independent view rather than determining the value themselves. Many attorneys are familiar with the business valuation process and could offer that qualified determination.
- However, the price is not fixed with business valuation arrangements, and uncertainty over final value in the process can be stressful and cause apprehension for the owners.
Buy-sell agreements are among the most efficient means of transferring dealership interests, as they can help forge smooth dealership continuation after disruptive events. By helping prevent infighting among co-owners and family members, buy-sell agreements can help minimize disruption and keep customer bases intact, and they can help prevent liquidity problems. The benefits of developing buy-sell agreements typically outweigh the costs.
Adapted from "Selling the Dealership, Part 3: How Do You Close the Deal?" previously published by Crowe.
