One of the major choices business owners need to make when drafting a shareholder agreement is whether to structure the transaction as a redemption or as a cross-purchase. When there are multiple shareholders, the remaining shareholders will still end up with the same ownership percentages; however, there are important differences that need to be considered.
In a redemption agreement, the selling shareholder sells their shares back to the company in exchange for either cash or stock. In a cross-purchase agreement, the selling shareholder will sell their shares to a new or existing shareholder directly. Again, the proceeds can be either cash or a note.
There are significant implications to all parties involved depending on which direction you take.
Advantages of a Redemption:
- Typically, it is an easier transaction. The company buys back the stock from the selling shareholder. The company will normally have more liquidity than a shareholder and probably greater access to capital.
- The seller does not have to find a willing buyer (either an existing shareholder or a new shareholder) to purchase the stock.
- Typically, the seller is more assured of being paid since the company, versus an individual, is the guarantor of any note. There may be ways to mitigate this risk but it becomes more complicated.
- The company may be able to get external financing if the selling shareholder is not willing to take back a note.
- If the company pays the departing shareholder interest, it can deduct the interest as an ordinary business expense (subject to certain restrictions).
- New shareholders are not as much “at risk” to make the payment to the selling shareholder.
Advantages of a Cross-Purchase:
- The purchasing shareholder gets tax basis in the stock that is being purchased. As a result, when that shareholder sells their shares, less tax will be due on the gain since their cost basis in the stock will be higher.
- If the purchase is funded by proceeds from a life insurance contract on the selling shareholder, the life insurance proceeds are not subject to an alternative minimum tax.
- In many cases, if a bank is already lending money to the company, the bank may require that any notes to a selling shareholder be subordinated to the bank if it’s treated as a redemption.
- The company’s balance sheet is not leveraged by the shareholder’s debt and the it does not need to provide financing to the purchaser (which is treated as contra-equity if the company is the payee on the note).
You could draft an agreement to allow either a redemption or a cross-purchase, but existing shareholders often want the buyback to be “guaranteed” by a life insurance policy should they die prematurely. In these cases, the decision has to be made about who the owner of the policy will be and that forces the decision whether to do a redemption or cross-purchase.
We have developed a process to assist our clients in making these complex decisions so please do not hesitate to reach out to us if you are contemplating a new agreement or just want to review your existing agreement.
David E. Shaffer
is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email.
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