Buy-Sell Agreements for Business Succession

Despite the name, a buy-sell agreement has nothing to do with the buying and selling of a business. A buy-sell agreement is part of a business succession plan to ensure continuity if a partner or co-owner leaves the business for any reason. The buy-sell agreement helps ensure that ownership interests are protected and stay within the company.

A buy-sell agreement is a legally binding contract that protects the other partners and owners in a business from possible disputes. It provides a source of funding for business partners who may have difficulty buying out a co-owner in the event of a departure.

What Is a Buy-Sell Agreement?

A buy-sell agreement outlines how an ownership share of a business will be transferred if an owner or partner leaves the company for any reason. If a partner dies, retires, or must step down for other reasons, the buy-sell contract sets the terms of a sale, dictates who can buy shares, and determines how the business is valued for the buyout.

A buy-sell agreement often provides a source of funding for the purchase. This helps partners avoid scrambling for funds in an emergency. Life insurance policies are a common source of funding for buy-sell agreements.

Components of a Buy-Sell Agreement

An effective buy-sell agreement must have three core components. These are not legal requirements, but they must be included for a workable agreement. They are:

• Triggering Events: The agreement must spell out what activates the agreement. Triggering events may be death, disability or incapacity, or termination from the company.
• Valuation Method: Business valuation should be done at the time the agreement is written, and it should also include a method of valuing the business if the agreement is activated. Ownership shares can be valued through a straight division by partners, independent appraisal, or other methods. Having a settled procedure in place can save the survivors from headaches.
• Funding Mechanism: The remaining partners or owners may not have the immediate cash to buy out the departing owner or their estate. The triggering event should activate a life or disability insurance policy to buy out the owner. Other options may include a lump-sum payment from the business itself, or allowing the other owners to make installment payments to the departing party.

If this sounds complicated, that’s because it usually is. Consider speaking with a business law attorney when drafting a buy-sell agreement.

Types of Buy-Sell Agreements

Buy-sell agreements are common in partnerships and closely-held businesses that need to maintain business continuity when one of a small number of owners or partners leaves. The type of agreement used depends on the needs of the business entity.

In a cross-purchase agreement, the other partners agree to buy the departing partner’s shares in the business. Cross-purchase agreements work well for small businesses with few owners or partners. Partners can take out term life insurance policies on one another and use the funds to purchase their shares. Disability insurance can be used for the same purpose.

Cross-purchase agreements can be used for retirement, divorce, and bankruptcy, although the legal language becomes more complex. Under a cross-purchase agreement, surviving partners who buy a deceased owner’s shares receive an income tax basis step-up equal to the purchase price.

In an Entity-Purchase Agreement, also known as a redemption agreement, the company itself buys the departing partner’s shares by having insurance policies on each owner. The company is listed as the beneficiary and pays the premiums.

In an entity-purchase agreement, the company is legally obligated to use the money to purchase the shares. The decedent’s estate must sell the shares to the company, which redeems the shares. The remaining owners generally do not receive an increased tax basis in their own holdings.

It is possible to have a hybrid agreement and use both methods for different circumstances. It’s a good idea to work with a business law attorney if considering either of these agreements.

Getting Legal Advice for Your Agreement

The basics of a buy-sell agreement can make it seem straightforward. Define your trigger events, make sure you have a funding arrangement, and sign on the dotted line. Some websites offer DIY buy-sell agreements for startup businesses, along with incorporation documents and operating agreements.

Unless one of the owners/partners has a strong background in business law, a DIY buy-sell agreement is not a good idea. A poorly-written agreement is probably worse than not having one at all. There are many factors to consider with the agreement that your attorney or financial advisor can explain. Most attorneys advise consulting an estate planner as well, since the trigger event may be one partner’s retirement. Common issues encountered while drafting an agreement include:

• Purchase prices: A fixed price that fails to account for changes in market value or changes in the value of the company itself can cause huge problems. Any definition of “fair market value” needs to include goodwill and business contacts.
• Restrictions on transfer: Any provisions to limit access to future partners must be part of your initial agreement. For instance, if a triggering event is one partner’s divorce, can their ex-spouse buy in? A related issue is “right of first refusal.” If a partner wishes to sell their shares, do their partners have the right to buy them out first? What if they can’t afford to do so? Any agreement must account for these disagreements.
• Tax implications: Some post-death transfers may create capital gains or estate tax issues for the business or other entities. Your estate planner or tax attorney can help you avoid some of those problems before the fact, but not after.
• State laws: How your business is set up can affect the transfer of ownership. For instance, corporations, limited liability companies (LLCs), and partnerships are governed by state codes. State laws can affect creditor claims, spousal rights, and stock-certificate legends.

A skilled attorney can help you avoid any legal pitfalls and ensure your buy-sell agreement is sound.

Get Legal Advice From a Business Law Attorney

Ensuring a smooth transfer of business operations if an owner or partner leaves the company is just as critical as starting the company in the first place. You can do this by having a business law attorney draft your buy-sell agreement and make certain it includes all the details you need. Speaking with a tax attorney is also a good move. Eliminating mistakes while drafting is much better than dealing with them after a triggering event.