FAQ Regarding Buy Sell Agreements

Although you’re just focused on building the business when you form a partnership, nothing lasts forever and change is inevitable. If a partner leaves or falls ill and is unable to continue his or her functions, you want to make sure you have a contingency plan in place.

One of the best ways to prepare for change, both expected and unexpected, is to sign a buy-sell agreement with the other partners. Below are answers to some of the most commonly asked questions about buy-sell agreements.

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When would a business need to have buy-sell agreements in place?

Almost every business that is owned by more than one party (co-owned) should have a buy-sell agreement (also called a buyout agreement) in place at the moment the business is formed or as soon as possible after that point. Each day that a business continues to operate without a buy-sell agreement increases the financial risk.

If there was a triggering event, such as the death or disability of a partner, the company has a mechanism for continuing operations. It could outline provisions where current partners have the right of first refusal to buy out the other owner’s share before other buyers could come in.

Are buy-sell agreements used for buying and selling businesses?

Despite its simple name, no, buy-sell agreements generally have very little to do with the buying and selling of businesses. Instead, buy-sell agreements are contracts that link co-owners of businesses together and controls when owners can sell their respective interests in a company or business. In addition, these agreements dictate who can buy an owner’s interest in a company and also sets the price at which the interest will be sold.

Buy-sell agreements only come into force when an owner of a business dies, retires, is bankrupted, becomes disabled or is divorced. Likening a buy-sell agreement to a prenuptial agreement is a valid comparison — they govern when a co-owner is getting out of the business just like when a couple is getting out of a marriage. Buy-sell agreements generally cover only transactions that occur between the business owners, which is why they are sometimes referred to merely as buyout agreements.

When a married co-owner of a business gets divorced, can the former spouse ask for partial ownership of the business or company?

It depends on the state that you live in and the type of marital property law your state follows. If your state follows a community property law system (like California, Arizona, Nevada and others), then all earnings that are made (and property acquired) during a marriage are considered the property of the “community,” meaning both spouses. Upon a divorce, the community property is split between the two spouses (absent a contradictory and valid prenup), so a former spouse may ask for partial ownership of a business.

In non-community property states, an ex-spouse may still make a strong argument for being granted partial ownership of a business that the other spouse was a co-owner of. This is because property laws require that marital property be divided equitably upon divorce.

Because of these laws, a good buy-sell agreement will adopt provisions that prevent former spouses from taking an ownership interest in the company on divorce from a co-owner. The agreements do this by requiring any former spouse who gets a property interest through divorce to sell that property interest back to the company or to other co-owners in exchange for cash or other valuable property.

If a co-owner files for personal bankruptcy, can this affect the business?

If the controlling buy-sell agreement is not carefully drafted, then yes, a personal bankruptcy could impact a business. If a co-owner does not have enough assets to cover his bankruptcy, the bankruptcy trustee may gain control and sell the co-owner’s share of the assets and use the profits to satisfy the debts. Because of this risk, most buy-sell agreements contain clauses that deal with such situations.

Typically, if a co-owner is about to file for bankruptcy, he must inform all the other co-owners of his situation. This then is treated as an offer to sell his ownership interest in the company back to the other owners. The money that is paid in this buyout goes towards the co-owner’s bankruptcy case.

Is there a best way to value a company when a co-owner is being bought out?

Perhaps the most accurate way of determining the value of a company when a co-owner is being bought out is to hire an appraiser at the time of sale. The appraiser will need to see at least one year of business records to make his decision. However, when a buy-sell agreement allows this to happen, what often results is that many owners hire their own appraisers who all come up with different valuation formulas.

To avoid this problem, it is often best to adopt a valuation method that will go into the wording of the buy-sell agreement. By doing so at the outset, this allows all the owners of the business to discuss and come up with an agreed upon valuation formula. If a formula is already set when it comes time to buy out an owner, it can save a lot of time and effort that would otherwise be wasted in picking and choosing between competing valuation formulas.

What happens if a company finds it necessary to buy out an owner but cannot afford to do so?

This often happens when a buy-sell agreement requires that an immediate, 100% lump sum be paid to an owner when it comes time for sale. It is often worthwhile to draft a more flexible payment scheme into the buy-sell agreement. Instead of requiring a 100% lump sum, allow a down payment on buyout between 25 and 35% of the value of the ownership interest up front with installment payments coming after for a period of three to five years.

Can buy-sell agreements allow a person to reduce estate taxes?

Yes. A buy-sell agreement is a good estate planning tool. By carefully drafting a buy-sell agreement, you may be able to reduce any potential estate taxes that you may owe at your death. If you are interested in using a buy-sell agreement to lessen or avoid any estate taxes, you should consult with an experienced tax attorney to find out your best options.

Do I need help from an attorney when drafting a buy-sell agreement?

It certainly doesn’t hurt to have an attorney help you draft — or at least review — a buy-sell agreement before the parties sign on. Even if you are absolutely confident about the terms of your buy-sell agreement, it may still be a good idea to get legal advice from a lawyer. Check FindLaw’s lawyer directory to find a business organizations attorney near you.

See FindLaw’s Partnerships section for additional articles and resources.