For business owners, making decisions for the business’ future will be a never-ending endeavor. It is easy to get caught up in focusing on day-to-day operations, but the long-term future of the business is typically the ultimate goal for any business owner. An important decision business owners should make is whether or not the business would benefit from having a buy-sell agreement in place.

What is a Buy-Sell Agreement?

A buy-sell agreement is a legally binding contract between the business and its owners that outlines the terms and conditions of how a partner’s share in the business is reassigned in the event of their departure from the business. The types of departures, also referred to as trigger events, could include:

• Death
• Retirement
• Physical or Mental Disability
• Voluntary Departure
• Divorce
• Bankruptcy
• Impasse over Major Issues

Buy-sell agreements typically prevent an owner from selling their business interest to an outsider without the consent of the other business owners. This agreement helps to minimize issues by providing orderly succession plans for your business. It helps to ensure a smooth transition of ownership and business continuity.

What type of business would benefit from a buy-sell agreement?

Having a buy-sell agreement should be a fundamental business practice. Any business structured as a Corporation, LLC, and Partnership with more than one owner should consider having a buy-sell agreement, including family-owned businesses.

What are the most common forms of buy-sell agreements?

Buy-sell agreements are generally structured in the following ways:

Cross Purchase Agreement: This is the simplest form of a buy-sell agreement and is best suited for businesses with just a few owners. In this type of agreement, upon the occurrence of a triggering event, the other partners/owners of the business purchase the interest of the departing owner at an agreed upon price. This is sometimes funded by life insurance.

Entity Purchase Agreement: This type of agreement is when the business entity itself purchases the departing owner’s interest, at an agreed upon price. This is sometimes funded by a life insurance policy where the business itself takes out a policy on each individual owner. This is oftentimes referred to as a redemption agreement.

Wait and See Agreement: This type of agreement is a hybrid between a Cross Purchase Agreement and an Entity Purchase Agreement. This type of agreement postpones the decision on who will purchase the interest of the departing owner until there is a triggering event. It offers flexibility and allows for the purchase decision to be made based on the circumstances at the time of the triggering event.

What is typically included in a buy-sell agreement?

Buy-sell agreements are typically constructed in a way that best suits the individual business needs. They must also be constructed to adhere to specific state statutes. Generally, a buy-sell agreement will include:

• A list of the owners/partners of the business and percentages of ownership.
• A methodology for determining the value of the departing owners share of the business, and the date the valuation is determined.
• A list of events that could trigger the buyout.
• The determination of which parties will purchase the interest, terms of purchase, security for payment, etc.
• Addressing certain tax and estate planning considerations for each of the owners and the business.

How is the business value determined?

Valuation methods are an important part of buy-sell agreements as they determine the price at which business interests are valued. This important component helps avoid potential conflicts should the parties fail to agree on value. Appraisers may be hired by the owners or the business itself to conduct valuations unless the agreement uses a simple methodology that can be implemented without expert help. Some of the most common types of valuation methods are:

*Asset based approach-This type of method focuses on the net asset value of the company’s assets.

*Market-based approach– This type of method compares financial metrics of similar assets to determine value.

*Income based approach– This is a valuation approach that uses the income generated by the business to determine value.

*Stipulated value– Where the owners agree in advance of the value of an interest for buy-out purposes.

How are the buyouts funded?

There are specific factors that generally influence how a buy-sell agreement is funded. These include:

• The size of the business.
• The business structure and tax issues.
• The number of owners and their percentage of ownership in the business.
• The structure of the buy-sell agreement in place.

It is important that the buy-sell agreement is properly funded so the buyout can be accurately executed and not cause any financial strain on the owners or the business itself. While there are a few options to fund a buyout due to the death of an owner, one common approach is to have a life insurance policy for each of the owners of the business. It can be the most cost effective and tax efficient approach to have money available in the event that an owner dies. However, insurability can be an issue and insurance premiums may be costly.

A few of the other options to fund a buy-sell agreement are:

Borrowing money from a lender- This option may be quick and provide the appropriate funding, but it also can lead to debt that might be difficult for the business to carry.

Installment payments- Making installment payments (either from the company or other owners) for the departing owners’ share of the business could cease cash flow pressure, but it can create ongoing financial obligations that may cause strain.

Sinking fund- This type of funding is where the owners of the business create a reserve account by setting aside a portion of the business profits each year in order to fund the buyout of a departing owner. This option avoids debt, but it takes planning, discipline, and time to accrue enough for the buyout, and tax impacts must be addressed.

Can a buy-sell agreement help a business avoid probate?

If this agreement is properly structured and fully funded, the transfer of ownership process can significantly reduce the need for probate and in some cases, avoid it altogether. Having the agreement helps streamline the transfer of ownership by minimizing delays and potential complications.

What are the main advantages of having a buy-sell agreement for your business?

Buy-sell agreements are designed to provide a smooth transfer of ownership and to help protect the business and business owners’ personal interests.

Buy-sell agreements:

*Implements structure to ensure business continuity and provides a clear path for business succession;

*Help minimize potential conflicts and provides family financial security;

*Protects the interest of the remaining business owners;

*Helps establish a fair valuation method for each of the owners’ interests;

*Provides tax benefits;

*Prevents the business from being taken over by outside ownership that may not align with the values or vision of the current ownership.

It is important for your business to have a well-crafted and properly funded buy-sell agreement. It ensures protection for the owners, their families, and the business itself should a trigger event occur.

Written by Beier Howlett

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