Every LBM business with multiple owners must have a well-structured buy-sell agreement in place to maintain the health and sustainability of the company. Whether you’re a seasoned entrepreneur or new to the game, there are a few items that play a critical role in a well-constructed buy-sell agreement that you should pay particular attention to in order to secure your business’s future.
For many independent dealers, multi-generational ownership is a common scenario, and you may own assets, such as real estate, that were purchased many years ago. Over the past fifty-plus years, the real estate where your business operates has likely soared in value compared to its original purchase price, posing challenges and opportunities. If this describes your business, here are a few ideas for tackling this issue:
Real estate value matters
If the operating business also owns the real estate, have you planned for how you will buy-out the value of the operating business plus the value of the real estate? For many dealers, the additional cost of buying out the real estate can make the buy-sell agreement terms unmanageable. Therefore, your best option is to determine how to separate the real estate from the operating business.
Separate entity or subsidiary
We recommend transferring real estate into a distinct entity, separate it from your operating business, by following these steps:
Appraise the real estate
Obtain an appraisal based on reassigning the property to a separate entity and not based on a sale to a third party that maximizes the value of the property.
Cost basis and tax calculation
Determine the cost basis of the property (e.g., purchase price plus improvements) and calculate the tax liability using the cost basis and appraised value.
Compare the estimated taxes from a sale to the market rent you can collect by leasing the real estate to your lumber business. If you currently have a large cash balance and you can recoup the tax liability quickly by charging market lease rates, then it may make sense to move the real estate into a separate entity.
Asset drop down
If high taxes and limited cash resources pose challenges, consider creating a subsidiary owned entirely by your current business. You can then transfer the real estate into this subsidiary to defer taxes while separating it from the business entity. Similar to running your business successfully, a critical part of a buy-sell agreement is to prepare to fund potential future expenses. If your real estate and operating business aren’t separate, funding partner buyouts could become problematic, even with insurance coverage. Here’s how to strengthen your position for successful buyouts:
Control the business buyout price
When you draft a buy-sell agreement, a critical consideration is how a partner’s interest will be valued if a trigger event occurs. For example, if three brothers each own equal shares of the business and one retires, set the buyout price equal to the estate tax value as of the month-end preceding the trigger event. In this scenario, the minority interest will be valued using both discounts for lack of control and lack of marketability. Further, the reduction in expenses to “normalize” the income statement when a minority interest is sold are typically less than when a control interest is sold. What this means for your business is a potentially lower buyout price and less cash needed to buy out the departing owner.
Regular valuation updates
Regardless of how your buy-sell agreement determines the sale price, it is critical to update this valuation every 2-3 years. This ensures insurance coverage aligns with the current business value and allows you to plan for expenses beyond the insurance coverage limits. To further help manage the cash flow in a buyout, we suggest creating a “sinking fund” with some of your cash reserves.
This fund can be invested conservatively for the sole purpose of funding future buyouts.
A well-structured buy-sell agreement isn’t just a legal formality; it’s a strategic investment in your business’ longevity and success. By addressing real estate complexities and maintaining financial readiness, you can navigate ownership changes confidently, ensuring a thriving future for you, your family, your employees, and your company.
If you’re seeking expert guidance, reach out to a valuation professional specializing in the LBM industry.