If and when this day happens how do the owners deal with this closure? In almost all cases the business has flourished and is now worth a tidy sum of money. Adding difficulty to the situation is that in most cases if not all cases there isn’t enough liquidity to fully discharge the position the departing owner carries on the books. This adds to the dilemma at hand and of course without the necessary financial means to separate the one departing owner, separation can get downright ugly.
To prevent an uncomfortable and embarrassing separation, the owners should agree on how to separate before joining together. Very similar to a prenuptial in marriage, a ‘Cross Purchase Agreement’ identifies the various business issues to address such as valuation of the ownership position, the respective form of purchasing the departing ownership and time period of payout. In addition, the Cross Purchase Agreement covers the tax implications involved and the position the Company will take in priority in regards to the various possible tax scenarios.
This article is the first in a series detailing the associated issues related to Cross Purchase Agreements. This particular article will introduce the concept of a Cross Purchase Agreement and address the business issues all owners should consider and understand when developing their Cross Purchase Agreement. Cross Purchase Agreements are legal documents. The next article will go into detail related to the tax implications. The final article offers some guidance on how to go about setting up the Cross Purchase Agreement and the best methods of discussing the various possible outcomes with all the owners. The key here is that all parties should have a so called ‘Meeting of the Minds’ in regards to an owner terminating their rights to an equity position in a business.
A Cross Purchase Agreement is a tool used by owners of a small business to facilitate the grounds and procedure to terminate the relationship between owners. The document covers the various business reasons for termination of the relationship and how to value the business related to the reason for termination. Furthermore, this document acts as the guiding procedure in the terminating process. It is legally binding between the parties upon signature. It should be signed at the same time the owners make their original investment into the business at start-up.
I encourage owners to have this document drafted and reviewed with a business attorney. A good attorney will include the following articles in the document:
- Valuation of the Business – explains the various methods and tools used to value a business and their corresponding application related to the different reasons for separation.
- Justifiable Separation – sets the standards for an owner to declare a justifiable separation or termination from the business and the applicable valuation tools for determining the departing owner’s monetary payment.
- Unjustifiable Separation – sets the minimum threshold for a justifiable separation and explains the ramifications associated with an unjustifiable separation or termination. In addition, if the separation is indeed unjustifiable then the particular valuation method or methods is predetermined. In addition any corresponding penalties and minority interest discounts are explained.
The standard articles found in the document include:
- Restriction on Transfer of stock to only those currently owning a position of equity in the company.
- Notification Process
- Right of First Refusal
- Sale Clause indicating time period to complete the transfer of stock
- Sale of Stock related to the following groups of separation or termination:
- Terms of Purchase
- Exchange of Certificates and Execution Process
- Amendment Process
Many people confuse Cross Purchase Agreements with other types of documents or contracts typically used in closely held business operations including:
- Non-Compete Agreements – covers the relationship issues associated with how a departing owner handles any knowledge or skills acquired while associated with the business.
- Buy-Sell Agreements – addresses capitalization issues for expansion of the company or the sale of equity to outside parties
- Management Agreements – generally associated with how management is appointed and their respective duties and limitations. Sometimes these rules are found in the bylaws of the company.
- Employment Agreements – contracts for employment for management and/or owners and for those key employees in the company.
Of all the above issues, the most concerning issue relates to valuation of the business. You would be surprised at how people determine value for a business. I have seen some crazy valuations or claims made by existing owners as to the value of the business. There is an entire section on this website devoted to explaining valuation in business. This article isn’t design to go into these details; it is designed to explain about the various business issues associated with a Cross Purchase Agreement.
When you go online to research this topic matter, most of the articles focus on death as the reason for ‘Cross Purchase Agreements’. Really, ‘death’? I would be insulted as this is one of the rare reasons for this document. I agree it is a legitimate reason, but I guarantee you it is not the primary reason for an owner’s desire to separate. The most common and higher ranking reasons for owners separating from the business are as follows:
- Misunderstanding Between Existing Owners – each owner has a different expectation from the other owner(s) therefore creating an environment of value shifting often in duties, responsibilities and time commitment by each owner.
- A Business Shift in Direction – the business started out with some goal and due to circumstances has shifted that goal to some new purpose and an owner disagrees; therefore a rift occurs between the owners.
- Change in Family Status with an Owner – additional children or marriage creates a new barrier that must be overcome between the owners.
- Retirement – one of the owners reaches retirement and would like to take his money and walk away from the company.
- Health – all of us will experience some catastrophic health issue at some point in our lives. Sometimes this changes the ability of an owner to perform their duties.
- Death of an owner
Notice how death is actually the least common reason for owner separation. What is most interesting it is the easiest to address by using life insurance to cover the exit value for the deceased. But, what about the other reasons for owner termination? How do they occur and how does a ‘Cross Purchase Agreement’ address them?
The following sections go into more detail about the above common reasons for creating a ‘Cross Purchase Agreement’ between the owners. In addition each subsection explains how a ‘Cross Purchase Agreement’ addresses measuring the problem and how to resolve the issue.
By far the most common reason business partners split up is the misunderstanding each has going into the relationship. I cover this in more detail in The Basic Principles of a Partnership. What fascinates me the most is how two people can so misunderstand each other when it comes to putting up several thousand dollars and a lot of time to make a business successful. Just as in marriage there are different expectations and work ethics. Some business partners desire only to invest the capital and no time, others don’t have the capital but have the knowledge and the energy to make it happen.
These fundamental understandings need to be addressed upfront before the actual company is started. Everybody needs to ask the other individual the following questions:
- What do you truly expect out of this business venture?
- What are you willing to do to make this business successful? Extreme measures?
- How much time and financial capital are you willing to invest?
- When are you ready to begin?
- Where do you see this business operation in one year and in three years?
- Why do you want to do this?
All of these questions are pertinent and the answers should be documented. If the individual states that they are willing to give up their existing job to make this company work; then all parties should understand what this means. Is this person risking their family’s source of livelihood to get involved? If so, don’t you think this is an elevated risk for this person? Should they be compensated in the form of monetary compensation in front of those owners that only risk capital or should they be lower and paid last for this venture?
These are important relationship issues that need addressing up front so that there is no misunderstanding between the parties. You should document the answers to the questions so there is a record of the understanding between the parties.
These various misunderstandings lead to a disgruntled relationship between the owners. This creates a desire by one of the owners to withdraw from the business operation. So for both parties to have a basis of understanding up front, the questions must be answered. This way, the remaining owner has substantiation for an ‘UNJUSTIFIABLE WITHDRAWAL’. If the Cross Purchase Agreement is written well, then the withdrawing party is forced to take a lower value for their respective share of the business. Seriously you need this concept: PUT UP WHAT YOU SAID YOU WOULD DO OR PAY A PRICE FOR FAILURE TO CONFORM.
In my introduction paragraph above I describe the unjustifiable separation aspect of the agreement. If the conditions and reasons warrant this classification of separation than the individual departing should be penalized for their failure to live up to their part of the bargain. If you are reading this article, please realize this is the most common reason for a disgruntled relationship between owners. I’ve seen this many times in my career and the reasons vary but typically follow along these circumstances:
- An owner doesn’t have the same work ethic as the others
- An owner believes they provide more value than other parties
- An owner has a different lifestyle requiring greater compensation to pay for that lifestyle (this happens a lot!)
- An intercompany relationship develops and undue risk is generated by one of the owners (basically an affair)
- One of the owners is unreasonable in handling business matters or fails to comply with the law or filing deadlines
- An owner’s absenteeism rate is higher than other owners (I’m talking about double the amount, not 5 or 10 percent)
- An owner’s management style is inappropriate for the particular industry and causes employee moral issues
This list can get extensive but you get the idea. Again, a misunderstanding between the owners is the NUMBER ONE reason a cross purchase agreement is needed.
I am willing to bet that this occurs over 80% of the time. In addition, unless all parties document the understanding upfront, there is no basis for using the UNJUSTIFIABLE SEPARATION clause of the agreement to determine the separation value paid to the departing owner.
The second most common reason for an owner’s withdrawal is a business shift.
As businesses grow and prosper they often shift their focus. This is more common than what many business entrepreneurs realize. As the business begins to expand and explore new areas of service or products something happens and a particular service or product begins to dominate the business operations. This new line of operations takes over and becomes the bread and butter of the operation. This often creates a rift with owners. One owner will want the business to shift back to the original purpose whereas another is truly interested in expanding on what is working well for the company.
This gets back to the age old issue of business. Are you about the idea or making money?
This brings up the primary reason to be in business. I talk about this a lot in my articles, why are you in business? I’m going to tell you that it is about the money and not about the product. The product falls to third place overall. First off, it is about making a profit then about providing security to the employees and finally it is about the product or service you provide. But the main reason is profit. Many owners of business fail to understand that given the risk they take, the resources given up and the stress taken on, you deserve an extremely high profit. Therefore, when the company shifts its purpose, some owners disagree with this change. So just like the misunderstanding section above, the parties have a rift in their relationship.
So how do you address this?
In most of these cases, the dominate focus of the business generally continues to exist, however, the one owner desiring a shift back to the original purpose selects or requests to withdraw from the business. So the big question is: Should the departing owner be penalized for wanting to shift back to the original purpose or goal of the business?
In my opinion it is a time question. If the shift has existed for several years e.g. more than 3; than the withdrawing partner should realize that they had plenty of opportunity to maintain the original course. If the new line of business is less than three years, I do not believe the withdrawing partner should be penalized in a monetary sense for withdrawing. The key here is to have a great accounting system that can quantify the growth of the new line of operations and account for the duration of existence.
Change in Family Status
A shift in family status occurs frequently with business partners. Most often it doesn’t create an issue for the business. But when it does you need to be prepared. Many closely held businesses are family owned so the owners are the parents and children. When the children marry or have their own children the business is affected. So these issues should be addressed beforehand.
The primary concern relates to continuity of the business partner related to their family status change. If one of the children marries will they continue as an employee of the company or does the new spouse desire to move away or have the business owner shift to a new career?
In general, most changes in family status are legitimate reasons to withdraw from the business. So the Cross Purchase Agreement should not penalize the withdrawing partner for their termination.
But there sometimes is the case of the new spouse demanding an elevated position for the owner or a greater compensation package. When this happens the owners should follow the policies and procedures laid out in the management agreement. If the particular owner fails to comply with the management agreement and decides to withdraw, then naturally the withdrawal is unjustifiable and therefore the penalty clauses should apply.
Once in a while an unfortunate family status change occurs and it creates a business dynamic that goes beyond the generally accepted business arrangements. I’m referring to a new family member that is born with a disability that will exist forever. In these cases, the Cross Purchase Agreement shouldn’t penalize an owner for departing or desiring to utilize the value of their ownership in the company to provide for the disabled family member. Many of the family owned or closely held businesses use some form of increased compensation to the parent of the disabled to help pay for existing lifestyle adjustments. In addition a trust is created to provide for the disabled family member and some of the stock of the company is transferred into the trust. Basically the trust becomes an owner of the company but is often denied voting privileges until a certain date or conditions have expired.
The key to the change in family status and its effect on the company focuses on whether this change is detrimental or acceptable to ownership. If the change creates a rift in the relationship, the departing owner should be penalized for terminating their position of ownership.
Sometimes change is for the positive such as retirement of one of the owners. The following explains how the Cross Purchase Agreement is structured to benefit the retiree.
There is nothing more enjoyable in the work environment than the retirement of an owner of a company. Often they have dedicated their lives to making the business successful and now it is time to reward them. When this happens it is time to restructure the ownership schedule and pay out the retiring owner their respective share of value.
The proper mechanism is an appraisal of the business via a business valuation. This is done several months in advance and it is highly recommended to get two of them done by two different CPA firms. Most small businesses can be valued for less than $15,000 but for some of your more elaborate business models, the valuations can cost upwards of $25,000 to $35,000.
But it is well worth the price.
The valuation is the primary underlying document to determine the buyout of the retiree. It is suggested that the management team use a weighted average formula to determine the value of a business. For those businesses with more capital dedicated towards heavy equipment or machinery, greater weight should be awarded to the book value of the assets and less with the business valuation. For real estate intensive operations, simple Fair Market Value of the holdings should have more weight applied.
Most Cross Purchase Agreements will assign a weight to three or sometimes four common measurement formats including:
- Business Valuation – done by an outside business firm such as CPA’s. Often the best and most reliable form of valuation. If done by two different firms, then each is assigned a 50% weighted value for this respective report. As an example, suppose Business Valuation is given a total weight in the formula of 75%, if two business valuations are delivered by two separate firms then each is assigned a weighted value of 37.5% (75% weight * 50% allocation). For those of you interested in understanding how a business valuation works, the website has an entire series here: Marginal Value in Business
- Fair Market Value – one of the easier valuation methods to assess asset value. It is simply what the market indicates at that moment. So if the books carry several hundred thousand dollars of publically traded bonds at the original purchase price, the business simply gets the current fair market value of the bonds and sets the value accordingly. Very simple to do with assets such as real estate, stocks, bonds, and in some cases collectibles.
- Book Value – not as reliable as the above two methods but more creditability is assigned the younger the company. If the company is only a couple of years old then odds are that the book value is not that far off from fair market value. But as the company matures and grows, book values become less reliable due to changes in the market which are not captured in the financial statements. Think of AOL. Remember when it was bought for some outrageous price back (Billions) in the early 2000’s? Do you think it is worth that today? The competition has reduced its value significantly and therefore the book value is less relevant today than it was 15 years ago.
- Liquidation Value – a fairly complex form of evaluating the fair market value of an asset. It is generally stated in the form of pennies on the dollar. For example many retail liquidations are stated in the seven cents to 18 cents on the dollar range for value of the inventory. For ongoing operations this valuation method is not used and actually frowned upon.
The Cross Purchase Agreement creates a formula to value the business for the retiring owner. Depending on the nature of the business determines which methods are provided stronger weights over the other methods. In general, the primary three methods are given some weight each in order to approach a reasonable and realistic value for the business. I once read the formula for a service based operation and I thought this one was fair with the following formula:
- Step One (Weighted Value of 80%) is a business valuation performed by a minimum 8 member CPA firm; excluded from the valuation is the value of the real estate.
- Step Two – add to the business valuation the appraised value of the real estate with a 90% value to an independent fair market appraisal and 10% to the city tax assessed value.
- Step Three (Weighted Value of 20%) is the book value of the capital accounts net of the real estate asset value and the corresponding mortgage debt.
When the totals came in, the business appraisal was performed without including the value of the real estate. The value was multiplied by 80% to create one number. The second number was a combination of the independent appraisal and city assessment (the city assessment was about 85% of the appraisal, so the city assessment dampened the appraisal value slightly when combined) and a value was calculated for the real estate. The third added number was a multiplication of the capital accounts by 20% net of the real estate. The value seemed pretty fair given the fact the owner desired to retire.
The second part of the Cross Purchase Agreement related to how the retiring owner was paid out for their respective ownership position. Basically the agreement stated that the ownership value as calculated above was paid with a deposit of 20% of the working capital available with the balance paid out over a 12 year annuity at a reasonable interest rate. Installments were monthly over the amortization period.
So sometimes the Cross Purchase Agreement works well especially for retirement the best part of operating a business. However, sometimes heath issues can create some serious problems. A well written Cross Purchase Agreement can address most of the health issues that can arise.
This particular issue is more depressing than anything else. Retirement is fun, but when health problems come out, now we have some serious problems to address.
There are five groups of factors that make all humans feel well. Good health is one of them (the other four include financial well-being, religion, significant other, and family). But for almost everyone, a health issue will happen. So the Cross Purchase Agreement is drafted to address the long term aspect of this issue related to an owner.
Make sure you understand my point here, short term health issues (less than 6 months) are usually addressed in the management agreement and with disability insurance. But long term health concerns are addressed in the Cross Purchase Agreement. Often long term problems dampen the profitability of the business because this owner isn’t working or working at a lower production level thus reducing overall profitability. At this point, the company has to hire someone to step in and take over this individual’s responsibilities. This costs money.
So to address this, a well drafted Cross Purchase Agreement provides for a period of time like two years whereby the affected individual will continue to receive a paycheck but compensation is netted against this individual’s equity position in the business. Some family owned operations will use a factor of like 70% or 50% adjustment in order to reduce the effect on the capital account. But after two years the price for the owner with the health issue is determined and a payout period is established.
In general, the Cross Purchase Agreement is providing an opportunity for the effected individual to recover; but after two and half years (remember the first six months is covered in the management agreement), recovery is unlikely so it is time to terminate this person’s ownership position. Most agreements allow for an annuity period to match the owner’s expected remaining life and payments are made based on this annuitized amount at a reasonable interest rate. This has very little effect on the cash position of the company and makes it easy for all remaining owners to pay their respective share of the payment.
In a family business situation, there is greater leniency towards the affected owner and in many cases, the business just flat out continues to pay the owner as an employee so they can continue on the health plan and the family does not feel the need to provide financial support. The main reason is to provide health insurance and take care of this owner’s family via a compensation package. Remember, one of the primary reasons for having a business is to create a ‘Legacy’ for the family and that includes all members of the family.
But the worse situation and the easiest to address is death.
The last reason and the one most commonly mentioned by most writers of Cross Purchase Agreements is death. Most of those that write about this are life insurance agents or brokers. So their goal is to earn a commission on the life insurance policies purchased on the owners of the company.
It is relatively simple formula. The company takes out life insurance policies on all the owners based on their respective ratios of ownership. Policy values are determined and then if an owner dies, the company basically purchases the ownership rights via life insurance proceeds.
The Cross Purchase Agreement sets the price up front based on a reasonable expectation and updates the policies every five years or so to reflect the growth of the company. So younger relationships have $100,000 or $250,000 face values on the policies and payout the entire proceeds upon the death of an owner and as the business matures, the policy face values are increased and I’ve seen $2,000,000 on each partner in a medical practice.
So the most common written subject matter with Cross Purchase Agreements is the easiest to address.
Summary – Cross Purchase Agreement
This article is the first in a series of articles explaining the Cross Purchase Agreement. The next article will examine the tax implications associated with the Cross Purchase Agreement and the final in the series will provide some general guidance related to your business. In addition I’ll provide the general outline of a Cross Purchase Agreement so you know what to look for in the agreement.
The business issues for a Cross Purchase Agreement are the most important aspect of why you need one. It is merely one of several different types of agreements between owners and managers of a small business. A Cross Purchase Agreement establishes the methods and procedures to determine value for an owner’s equity position in a business under certain circumstances. These include 1) a business misunderstanding between the partners over time, 2) a shift in the business’s focus over time that goes against an owner’s belief in direction, 3) a change in family status including marriage, birth of new child or divorce, 4) the best reason – retirement, 5) health issues and God forbid 6) death.
The Cross Purchase Agreement has clauses explaining the different methods of valuation and the respective formulas for each of the above reasons and any discounts or penalties if applicable. Remember this document is an essential piece of the overall set of agreements between owners. Without this document, the legal process will take an extreme amount of time to adjudicate a case and in most situations will follow the methods and formulas I illustrate above. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.