Partnership Change: How To Plan Ahead With a Buy-Sell Agreement

When people start a business together, they are known as business partners. Sometimes, though, someone might want to leave the partnership or be unable to continue forward with the partnership. This is where a buy-sell agreement comes into play.

A buy-sell agreement allows you and your partners to plan ahead for bumpy roads when a partner leaves the business. This is a very important legal document that all business partners agree to. It helps everyone know what will happen if a partner needs to share their share of the business, also known as an owner's interest.

This article addresses how your small business can plan for partnership change through drafting a buy-sell agreement.

What Is a Buy-Sell Agreement?

A buy-sell agreement is like a plan for the future of your business. It's sometimes called a business buyout agreement or a partnership buyout agreement. In general, a buy-sell agreement is a contract between all the partners in a business that deals with the future ownership of the business and partnership change. 

This agreement is a promise between co-owners of the business about how an owner's interest in the business can be bought and sold. Everyone agrees on the purchase price and how to handle the change if someone leaves the company.

Because a buyout agreement is a binding contract, it can either stand by itself, or it can be included in the partnership agreement. It should generally cover important business decisions, such as:

• Whether a partner can be bought out when they depart the business
• The amount that an ownership interest will be valued at (called the valuation formula) when a partner leaves
• Who can buy a partnership interest when a partner departs (this can include outsiders to the partnership, but is often limited to pre-existing partners)
• What events can trigger a buyout

As some commentators have put it, another way to think of a buyout agreement is like a prenuptial agreement for businesses. Even though you may all think at the outset that the partnership will last forever, sometimes things happen that will break up the partnership.

What Events Are Covered Under a Buyout Agreement?

As noted above, a buyout agreement will generally spell out what kinds of events will trigger a buyout option. These events typically include:

• The retirement of a partner
• A divorce settlement agreement in which a former spouse of a partner is going to receive an ownership interest in the business
• An attractive and lucrative offer from an outsider to buy a partner's interest
• A foreclosure of a debt that was secured by a partnership interest
• The filing for personal bankruptcy by a partner
• The death, permanent disability, or incapacity of a partner

What Are the Four Types of Buyout Agreements?

There are typically four types of buy-sell agreements:

• Cross-Purchase Agreement: Other partners buy the departing owner's share
• Redemption or Entity Purchase Agreement: The business itself pays the departing owner's share
• Hybrid Agreement: A mix of both cross-purchase and redemption agreements
• Wait-and-See Agreement: The business and the partners wait to decide how to buy the share when the time comes

These agreements cover events like retirement, death, or if a partner just decides to leave. They make sure the business can keep running smoothly.

Why Do I Need a Buyout Agreement?

Not only is a buyout agreement like a prenuptial agreement for businesses, but it will also remind all the partners of how you have all agreed to handle the sale or buyback of an ownership interest in the event of a partnership change. 

If you and your partners do not have a buyout agreement, your partnership might have to be dissolved by the law if one partner decides to leave the state and start his how business in another. This would force you and your partners to divide all the assets of the business and start building from scratch.

Even if your partnership is not coming to an end, you and your partners may still disagree on who should buy an ownership interest of a departing partner and how much the ownership interest should be bought for. There have been numerous legal battles over the valuation of an ownership interest at the time of sale because the business owners forgot to make a buyout agreement where they set a valuation formula. This could lead to costly litigation and business delays.

Lastly, buyout agreements also dictate what kinds of outsiders can buy into a partnership. If you do not have a buyout agreement in place, you may end up running your business with someone that is distasteful to you.

Getting Started With Your Buyout Agreement

To start making your buy-sell agreement, you'll need to talk with your business partners about what everyone wants and expects. You should discuss:

• The fair market value of each partner's share
• How to figure out the purchase price when it's time to buy someone out
• How the money will be paid to the departing owner
• How to handle the remaining partners' share of the business

Then, with legal help, you can write down your plan in an operating agreement or another kind of legal document.

Common Buy-Sell Agreement Mistakes

Here are some mistakes people often make with buy-sell agreements:

• Not having one at all
• Not updating it when things change in the business
• Forgetting to plan for all the possible reasons a partner might leave
• Not being clear about how to figure out the purchase price

To avoid these mistakes, partners should work with legal experts and regularly check the agreement to make sure it still fits the business well.

Need Legal Help With a Buy-Sell Agreement?

Buy-sell agreements, as with most business contracts, can get quite complicated. Before you agree to the terms and sign such an agreement, it may be wise to have a business organization attorney review it. Even if the attorney finds no issues with the contract, it will afford the parties more peace of mind knowing an attorney reviewed it.