Buy-sell agreement key to orderly transition

Question: I'm a physician investigating the creation of my own private medical practice with a partner. I've heard when organizing a business entity, it's a good business practice to include a buy-sell agreement. Can you explain?

Answer: You can think of a buy-sell agreement as a prenuptial agreement for your practice, because it establishes what happens if someone leaves your business marriage.

The buy-sell agreement is an arrangement in which owners of a corporation or partnership agree that remaining owners have first rights to buy the interest held by a departing or deceased owner. A buy-sell agreement provides for an orderly disposition of an interest in a business and is beneficial in setting the value of such interest for inheritance and death tax purposes. It also prevents a withdrawing owner from selling shares to an outsider without the partners' consent.

In fact, some state statutes governing the statutory close corporation -- a company whose incorporation documents specifically state it will have no more than 30 to 35 investors -- actually mandate that the owners enter into a buy-sell agreement.

The agreement usually takes one of three forms.

The first is called a cross-purchase agreement. It says is that a withdrawing partner agrees to sell to the remaining owners. The individual owners fund the purchase from their own pockets, and the deal sometimes has provisions allowing for a down payment of, say, 25% to 33% because of the difficulty of coming up with a 100% lump sum at once. If sale is prompted by the owner's death, then the purchase also could be financed by proceeds from a life insurance policy. In a cross-purchase agreement, the owners take out life insurance policies on each other, naming the other owners as beneficiaries.

The second kind of agreement is called an entity-purchase agreement. It is similar to a cross-purchase agreement except that the practice, rather than the individuals, purchases the ownership interest. Any life insurance policies would name the practice, instead of the individuals, as the beneficiary.

The third kind of agreement is the most flexible. It's called a hybrid agreement, and it's a combination of the cross-purchase and entity-purchase agreements. The withdrawing owner must first offer his ownership interest to the entity. If the entity declines or is unable to make the purchase, then the shares must be offered to the other owners.

In any agreement, ownership certificates must be endorsed with notice of the restriction on transfer created by the buy-sell agreement. In many cases, state statutes require that precise language be used in the ownership certificates. Therefore, it is important to examine your particular state's statute and incorporate the exact required language into all ownership certificates.

The proper buy-sell agreement describes not only how an interest will be sold, but also how the value will be established. It also includes some language to cover some common, but often unforeseen, events that might affect a sale.

For example, a buy-sell agreement can include language requiring a partner to inform the others before formally filing for personal bankruptcy, and making that an automatic event to sell shares back to the other owners, or to the entity. That money would go to the bankruptcy trustee. This prevents, in a worst-case scenario, a bankruptcy court forcing the liquidation of a practice to raise money for a bankrupt owner's debts.

Another example is a case of divorce. In many states, particularly those with community property laws, a divorced spouse might be entitled to a partial interest in the practice. Many agreements have written into them clauses that in the event of a divorce settlement, the practice or its individuals would buy back the interest of the divorced spouse.

Such clauses make it even more important that a method for valuing the business interests of your medical practice be spelled out. To simplify the buy-sell process and ensure fairness for all owners, the buy-sell agreement should specify how the owner's interests are to be valued.

There are essentially three choices: the book value approach (adding all assets and deducting all debts and liabilities); the fair market value approach (the price a practice would likely sell for on the open market); and the formula approach (using a predetermined formula to establish the practice's value).

The agreement could also make valuation subject to the circumstances of the partner's departure. If it's a case of death or disability, the shares of the practice would be valued at their full amount. In the case of a voluntary withdrawal, the interest can be valued at a lower amount.

If you are an owner or plan to be an owner of a medical practice or any business, you should know if there is a buy-sell agreement in place. If not, you should consider providing for one.