Buy-Sell Planning for Franchisors or Franchisees

A well-constructed buy-sell arrangement can provide peace of mind for you and your family that there is a succession plan in place to help take care of the needs of all interested parties.

By Adam Goddard

Franchise owners face many of the same challenges as other business owners: How do I continue to grow my business? How do I recruit and retain key talent? How do I protect against unexpected losses? How do I get money out of my business in the most tax-efficient way?

A good financial advisor can help franchisees address these issues. This is the first in a series of articles to help explore strategies in the following areas: Buy-Sell Planning, Aligning Your Business and Personal Goals, Retaining Key Talent, and Funding Retirement for Franchise Owners. This discussion will focus on buy-sell planning for franchisors and franchisees.

Buy-Sell Planning

Buy-sell arrangements are a key business protection tool and should include both a buy-sell agreement and an identified source of funding. A buy-sell agreement is a written document that is a legally binding contract, between two or more parties (such as co-owners of a business), that obligates one party to purchase the other’s business interest, upon one or more pre-identified triggering events (such as death, disability, divorce, or retirement), at a set or formula price.

You should be focused on creating value and your financial advisor should be focused on helping you to protect that value. This includes both protecting the value and you and your family. As a franchisor or franchisee owner, what would happen to your family if you died unexpectedly? Would they have enough money to provide for their needs? Further, has the franchisor pre-approved ownership following the operation of your buy-sell agreement?

What would happen to your business? If you are a franchisee, is there a redemption (right of first refusal) agreement in place with the franchisor? If there is no formal buyout provision, would your spouse have to start working in the business? That could be very awkward. How would that work with the existing management team and your co-owners, if any? Is there a potential successor that could purchase the business from your heirs? And if so, would he have the financial wherewithal to make such a purchase?  

A properly executed and funded buy-sell arrangement can provide more protection for a business owner’s family (and for co-owners or other potential successors). This is especially important to have when a “triggering event” occurs such as death, disability, divorce or change of control.

Five Questions

As you think about protecting the value of your franchise, consider the following questions:

Who would take over your ownership interest and operating responsibility in the company if something happened to you?

The answer, of course, may depend on the terms of your franchise agreement. If you’re a franchisor, there are at least four potential candidates to be your franchise successor. The terms of your franchise agreement may require that the franchise sell back to the franchisor (as mentioned above, a ROFR). You may be co-owners of a franchisee and your co-franchisee(s) would be the most likely successor. There may be other franchise owners in your community who would be interested in buying you out. There might be a key employee who could be groomed to run the franchise after you. Depending on the size and growth of your business, your company may also be an appealing acquisition candidate for a third party buyer. A knowledgeable investment banker with experience in the world of franchisors and franchisees could be a critical advisor to you on this point.

Do you currently have a written/funded buy-sell arrangement for your business? 

A buy-sell agreement is every bit as important for a business as is a will for individuals. Without a buy-sell agreement, there may be no plan for unexpected contingencies. Would your spouse continue the franchise? Is this realistic? Wouldn’t it be better to leave cash?

If you do not already have a buy-sell agreement in place for your franchise, you may expose your family to financial hardship or a difficult negotiation with co-owners, key employees and key vendors. You can protect them better with a thoughtful, well-designed business planning.

Are you sure you have a buy-sell agreement?

This may sound like a trick question, but it isn’t. Many partnerships and limited liability companies have operating agreements which have provisions in them which sound like buy-sell provisions. And many franchise agreements include similar provisions. In both cases there is language in the agreement that talks about what would happen if the business owner or franchisee dies. But close examination of the language reveals that it only provides for an “option to purchase.” In other words, the co-owners or the franchisor are given an opportunity to buy the interests of a deceased owner, but may not be obligated to do so.

This fails the protection test. We began this discussion of buy-sell agreements with the idea of providing real financial protection for the franchise owner’s family. But the family is not protected unless someone has an obligation to provide cash (on a very timely basis) in exchange for the deceased owner’s franchise interests. Without an obligation, the family may be exposed to potential financial hardship.

Is the buy-sell agreement funded?

It is one thing to have an agreement that obligates someone to pay cash to your family in exchange for your franchise interest. It is another thing altogether to make sure that cash is actually available. If you do have a buy-sell agreement, where is the money supposed to come from to buy out your family in the event of your death? 

There are several options for funding such an agreement:

Current cash flow: You could assume that the franchise will be able to fund such an obligation out of its future profits. But this could be risky for your family since it is hard to predict what a franchise’s cash flow will be in the future. 

Sinking fund: Alternatively, you and your designated successor could start setting aside money each year so that funds are available when needed. But it is hard to know how much to set aside unless you also know when the funds will be needed and the value of the franchise.

Life insurance to fund buy-sell agreements: Life insurance can be a good financial tool when used for protection in that it uses the principal of “discounted dollars” for its funding strategy. It provides the funds when the funds are needed, whether next year or 20 years from now. Further, the death benefits are typically received income tax-free. Sinking fund options don’t assure this and cash flow may not be enough to buy out a shareholder (and can put significant cash flow constraints on the franchise).  

Will the pricing mechanism for your buy-sell agreement work?

Fixed price buy-sell agreements are simplest. All the owners have to do is agree on a price. Unfortunately, the fact is that most owners don’t update their agreements, creating real problems if value changes over time.

Formula agreements are formed by some business owners. However, no formula will work consistently over time with the myriad changes that occur within a company, its industry and the economy. This leaves pricing mechanisms determined by independent appraisers. The owners can agree on an appraiser for the buy-sell agreement. That appraiser will provide a value for setting the price initially and then annually (or less frequently) thereafter.

Other Considerations

Make sure to look at comparable businesses in similar industries for multiples of earnings to see if you’ve got a competitive valuation pricing. You want to have a good valuation to get a higher end buyout if possible. That involves making sure the business is running efficiently, so look to consultants and experts who can help you enhance your value coming into the sale or bidding process. Get an outside valuation to firm up your asking price (which will also be due diligence to show to the buyer).

As the owner of a business and a provider for your family, you need to make a plan to protect both in the event of your death, retirement or some other event. A well-constructed buy-sell arrangement can provide more peace of mind for you and your family that there is a succession plan in place to help take care of the needs of all interested parties.

Adam Goddard is a financial advisor with the Capitol Bay Group.

Note: This information is being provided only as a general source of information and is not intended to be the primary basis for decisions. It should not be construed as advice designed to meet the particular needs of an individual. Seek the advice of a financial advisor regarding your particular financial concerns. Consult with your tax advisor or attorney regarding specific tax issues.