Cross Purchase Vs Buy Sell: Everything You Need To Know

Using cross purchase vs buy sell helps to solve several issues that may arise during the execution of a joint business venture.3 min read

Using cross purchase vs buy sell helps to solve several issues that may arise during the execution of a joint business venture.

A cross-purchase plan requires stockholders to purchase and own life insurance on other stockholders. The value of the insurance proceeds must be equal to the value of the other's ownership interest. When a stockholder dies, the insurance proceeds are used to purchase the deceased's ownership interests from the family or estate.

A cross-purchase plan becomes cumbersome for business entities with more than two stockholders. If such is the case, owners should use a "trusteed" cross-purchase arrangement.

In this instance, a trust owns insurance life policies on each stockholder and represents the other members n the agreement. Upon death, the trust distributes the stock of the deceased shareholder to the remaining stockholders.

In the event of a total disability on the part of one stockholder, disability buy-sell insurance can be used in the cross-purchase agreement to facilitate the transfer of ownership.

Buy-Sell Contracts

A buy-sell contract allows a corporation, shareholders, or business partners come to an agreement about the terms and conditions of a future sale of business interest. Such an agreement is indispensable under disruptive circumstance since it enables a smooth transfer of ownership interests in the event of a bankruptcy, insolvency, loss of professional license, termination of employment, a partner's death, retirement, or receipt of third-party offers to purchase the business.

The contract gives owners a ready market if they decide to sell their interests in a business entity. It reduces disputes, resolves issues concerning estate liquidity, and establishes a framework for determining the purchase price of the business interest.

A buy-sell contract improves the morale of business owners since it helps ensure transition stability.

Buy-sell agreements usually specify the following:

  • The kind of agreement.
  • Trigger events that may cause an optional or mandatory buyout.
  • Terms of purchase and a baseline purchase price.
  • Description of the valuation date determined by the agreement.
  • A non-compete agreement between concerned parties.
  • Types of transfers that are prohibited under the agreement.
  • Types of transfers allowed under the agreement.
  • Approved methods for funding the agreement.

Buy-sell agreements are applicable to all organizations including general partnerships, limited partnerships, joint ventures, limited liability companies, S corporations, and C corporations. However, the triggers and particular kinds of agreement may vary depending on the ownership and nature of the business entity. No matter the type of agreement, it should be kept up to date and provide a procedure for determining the purchase price.

When drafting buy-sell agreements, there are a number of ways to value the business interest.

Fair Market Value

This is the price (expressed in cash equivalents) at which a business interest may change hands between a willing/able buyer and seller. The buyer and seller must have a reasonable knowledge of relevant facts, be under no compulsion to buy or sell, and act in an open and unrestricted market. Under such a scenario, a 20 percent interest in an entity valued at $200 may be worth $30 due to discounts for lack of ready marketability and control.

Fair Value

This is interpreted as what is equitable or fair and is usually defined by case and statute law in the state where a business entity is organized.

In some states, a fair value may include discounts for lack of ready marketability and lack of control. In states where fair value isn't subject to discounts, a pro rata value of 100 percent is applicable. Under fair value statues, a 20 percent interest in an entity valued at $200 will be worth $40.

Formula Pricing

This is a method used to estimate fair market value. Formula pricing appeal to parties engaging in buy-sell agreements since they are inexpensive to determine and very objective. However, they don't take into consideration subjective values that could influence the fair market value. Parties intending to use formula pricing should do a periodic review to ensure that the formula still represents their intentions.

Book Value

The value of a business interest can be defined as the net value of its books as recorded in tax returns, audits, and internal financial statements. It can also be determined using GAAP (generally accepted accounting principles). However, this value is not usually indicative of fair market value.

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