Buy-Sell Agreements: Safeguarding a Transition in Ownership
A buy-sell agreement is like a prenup for business. It protects you, your co-owners, and your company if circumstances change and one of the business owners leaves.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract for managing an ownership transition if an owner departs the business. Also called a buyout agreement, these contracts establish rules and guidelines for who can buy a departing owner’s shares, how the value of the business will be determined, and how each owner’s interest will be valued.
Buy-sell agreements are typically triggered when an owner dies, retires, or becomes disabled. They can also address the sale of an ownership interest in the event of divorce or bankruptcy or if a partner leaves for another reason.
Types of Buy-Sell Agreements
The three types of buyout agreements are:
- A cross purchase agreement
- An entity purchase agreement
- A wait-and-see agreement
A cross-purchase agreement directs the remaining owners (or the surviving owners in the event of an owner’s death) to purchase the departing owners’ interest. In some cases, it might give co-owners the right of first refusal to acquire the departing owner’s interest and allow for a third-party sale if they decline.
An entity purchase agreement (also called a redemption agreement) allows the business to purchase the departing owner’s share of the business.
A wait-and-see agreement, or hybrid agreement, allows for the purchase of a departing owner’s shares by either the business, the remaining owners, or both. The decision isn’t made until the triggering event occurs.
A wait-and-see agreement usually gives the business entity the first option to buy shares from the departing owner. If the business can’t or won’t acquire the shares, they’re offered to the remaining business partners, and if they won’t or can’t purchase the full ownership interest, the business must acquire the rest.
Types of Businesses That Use Buy-Sell Agreements
Buy-sell agreements can be used by business entities such as limited liability companies (LLCs), partnerships, and privately held or closely held corporations as long as they have more than one owner. Sole proprietorships can also use buy-sell agreements to plan for the sale of the business to a key employee if the owner dies or chooses to leave.
Why Should Small Business Owners Use a Buy-Sell Agreement?
Chances are your exit strategy imagines the best possible scenario: You build your business into a robust company that can sell for a substantial sum when you’re ready to retire or move on to another venture.
But the reality is that many more events can trigger a business exit. As the saying goes, “Life is what happens when you’re busy making other plans.” By using a buy-sell agreement to plan for unexpected events, business owners can:
- Protect the business and co-owners
- Avoid potential disputes and legal battles
- Restrict the sale of the business to outsiders
- Maintain control of the business
- Aid in tax planning
How a Buy-Sell Agreement Protects the Business and Co-Owners
A buyout agreement ensures business continuity and a smooth management transfer, keeping disruptions to a minimum.
Suppose an owner dies, leaving assets to a spouse or children. Without a buyout agreement, the surviving owners may find themselves partnered with a family member who has neither the interest nor the ability to run the company. A buyout agreement can require surviving heirs to sell their shares back to the business or its owners.
A divorce can have similar repercussions. Community property states and others will deem an owner’s business interest community property, leaving the other owners to contend with a disinterested or angry spouse if they cannot buy back their interest.
Likewise, an owner who files for bankruptcy can open up the business to decisions by a bankruptcy trustee and liquidation to pay creditors. At the very least, the business can be hamstrung while the bankruptcy winds its way through the court process. A buyout agreement can ensure that the bankrupt owner’s shares remain with the business and not with lenders or creditors.
The unexpected death of an owner also jeopardizes the business when there’s no clear-cut buyout plan. Disagreements about how to handle the shares of the deceased can disrupt the business, and, in the worst-case scenario, land the remaining owners in a lawsuit to resolve disputes.
Some states mandate buyout agreements for certain business entities, and others require partnerships and LLCs to dissolve if an owner departs. It’s easy to see how co-owners can lose control of their business if they fail to include a buyout agreement in their business succession planning.
How to Make a Buy-Sell Agreement Work for You
Creating your buy-sell agreement when you first form your business is a good idea. If you wait until a need arises and the business owners are under pressure to arrive at consensus, the conversations around a buy-sell agreement are likely to get uncomfortable at best and adversarial at worst.
Your buy-sell agreement should consider many factors to ensure that it protects the owner who departs, the remaining owners, and the business.
Consider these tips and tactics when creating your agreement.
Work With an Attorney and CPA
Using an attorney and certified professional accountant to craft your buyout agreement ensures that it covers all the necessary contingencies, includes adequate provisions for funding a buyout, and follows the legal language needed to hold up against challenges.
Include the Events that Can Trigger a Buyout
In addition to death, disability, retirement, divorce, and bankruptcy, you’ll also want your buyout agreement to cover the involuntary discharge of an owner and voluntary exits.
Include the Owners Names and Their Equity Stakes
The share of ownership held by each owner is most often a percentage based on the owner’s investment. Sometimes, however, the contributions an owner makes to the company’s operation are also considered in determining the stake they hold. Regardless of the method you use to determine each co-owner’s percentage of ownership, it should be documented in the buyout agreement.
Specify Who Can Buy the Business
If you intend to restrict sales to existing owners, your buyout agreement must require them to buy out the departing owner’s shares. Owners should consider who they do and don’t want to work with when crafting a buyout agreement.
Set a Business Valuation
You can establish a valuation method for determining the purchase price or set a price. If you set the price, however, you’ll have to update your valuation periodically to account for changes in the market and the business.
Your valuation method can be based on fair market value, book value if the company were to be liquidated, or a formula such as a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization) or seller’s discretionary earnings (SDE).
Consider specifying whether an independent appraisal must be used in setting a purchase price.
Require Notice for Events Like Divorce
It won’t do much good to have a buyout agreement that specifies what should happen in the event of divorce, bankruptcy, or a voluntary exit if any of these events occur before you’ve had an opportunity to address them.
Require notice of intent to file for divorce or bankruptcy and advance notice for voluntary exits, so the remaining owners can implement the plans in the agreement.
Establish a Method of Funding Buyouts
Most small businesses purchase life insurance policies to fund a buyout if a co-owner dies.
Each co-owner buys a life insurance policy on the lives of the others, and the death benefit can then be used to fund the buyout.
For other types of exits, consider including other funding methods, such as:
- Establishing flexible payment terms over a period of time
- Setting aside a percentage of company profits for buyouts
- Buying disability insurance to cover a buyout if an owner becomes incapacitated
Consider the Tax Implications of Your Buy-Sell Agreement
An effective buy-sell agreement will provide liquidity to help pay state and federal estate taxes and avoid unfavorable tax consequences.
For example, life insurance benefits are generally tax free, so co-owners won’t incur taxes on the death benefit payout.
In general, sellers are subject to capital gains taxes on the stepped up value of the sale (the difference between the original investment and current fair market value). But the shares the co-owners buy from the departing owner will usually be valued based on the price they paid for the shares at the time of the buyout, resulting in lower capital gains taxes when they sell later.
Working with a tax advisor or other tax professional is essential when drafting a buyout agreement.
Include a Process for Modifying the Buy-Sell Agreement
Make sure you can adjust your agreement if there are changes in the business or market conditions. Review your buy-sell agreement periodically to address any changes needed.
As a business owner, assembling the right team of advisors is essential to help you plan your exit. Enlisting a CPA, attorney, and business broker can help you draft and understand the value of a buy-sell agreement. Visit the BizBuySell Broker Directory to find a business broker to suit your needs.