Cross-purchase agreements offer advantages

Janet Arrowood

There are several ways to structure a buy-sell agreement for a business. Two of the most common ways are the cross-purchase agreement and entity purchase (or stock) redemption agreement. This column will focus on the features and benefits of the cross-purchase agreement.

In a cross-purchase agreement, the owners of a business, ranch or farm agree between or among themselves to purchase the interest of a withdrawing, retiring or deceased shareholder. This form of agreement sets up a crisscross structure. 

Consider an example involving two owners. They might each own half the business or some other proportion. Either way, the agreement specifies how and when the one owner will buy the other’s share. Owner A agrees to buy 100 percent of the shares or stock of Owner B. The agreement is executed when some sort of triggering event occurs — usually a disability, divorce, death or retirement.

In a situation in which there are three or more owners, whether or not they own equal shares, each owner agrees to buy a predetermined portion of another owner’s shares or stock when one of the triggering events occurs. 

With more than two owners, the structure of the agreement can get complicated. Consider the following ownership structure. Owner A owns 40 percent of the company. Owners B and C each own 30 percent. The agreement is for each remaining owner, following a triggering event, to purchase 50 percent of the departing owner’s shares or stock.

If Owner A is the subject of the triggering event, Owners B and C would each acquire 20 percent additional interest in the business, making each a 50 percent owner. While this would change the dynamics of the company ownership, no single owner would have a majority interest. Compromise would be the order of the day.

If Owner B or C is the subject of the triggering event, things could get interesting since Owner A would acquire an additional 15 percent interest for a total of
55 percent. The other owner would only have a 45 percent interest. This could result in some possibly unintended — or undesirable — dynamics. Owner A would go from having to collaborate in the decision-making process to commanding full power to make all decisions and financial commitments.

Why, despite the potential complications, is a cross-purchase agreement so important? Because the alternative scenarios and outcomes are painful to consider. What might happen without the ready made market for an owner’s shares or stock when a triggering event occurs?

If an owner becomes disabled, there might be no plan or means to buy out the interest in the business. This owner would still control shares without contributing to the bottom line. This could result in the business failing, not performing as well as pre-event or (ultimately, through death or sale) having the shares end up under the control or ownership of someone else.

If an owner wants to retire, the agreement creates an orderly valuation process and means to acquire that owner’s shares or stock so the remaining owner or owners retain control of the business.

If an owner divorces, the agreement can include provisions that prevent the former spouse from acquiring a stake in the business by creating a purchase mechanism for the divorcing owner’s shares or stock. After all, the other owners probably don’t want to be in business with the divorcing owner’s former spouse. Even more important, there are some types of businesses that can only be owned by a qualified individual or group — a law or medical practice, for example.

If an owner dies, the agreement sets out how the shares or stocks will be distributed, ensuring the continued smooth operation and viability of the business. Even more important, the agreement helps reduce the likelihood of the surviving owner or owners going into business with the deceased owner’s heirs.

Disclaimer: This column offers a highly simplified explanation of a complex topic. This column isn’t intended to provide financial, legal, tax or other advice or recommendations. Always consult the appropriate licensed professionals when it comes to business, estate, financial or tax planning.