A buy-sell agreement is an agreement between the co-owners of a business which specifies what happens if one or more of them needs to exit the business. This may happen because the co-owner dies, is forced to depart or chooses to leave. It is sometimes likened to a prenuptial agreement made before a marriage that specifies what would happen in the event of a dissolution.
A buy-sell agreement may be contained in the agreement that establishes the business at its inception, e.g. a partnership agreement, or it can be a completely separate agreement. They are also called “shareholder” or “succession” agreements.
A buy-sell agreement serves two critical purposes:
- It limits how an owner’s interest in the business can be transferred;
- It sets up an orderly transition of ownership in the event of an owner’s death, retirement, or disability and averts any possible crisis that might result from leaving important issues to be decided until an unexpected and difficult time in the life of the business.
A buy-sell agreement might also have provisions regarding what would happen in the event of a divorce or the bankruptcy of an owner.
An effective buy-sell agreement describes:
- When and how, a business may sell an owner’s interest in the business;
- Whether the other owners or the business have the opportunity to buy the interest of another owner prior to its sale to an outside party;
- How much a purchaser would have to pay for an owner’s interest in the business;
- What role the remaining owners would pay if a departing owner’s interest were to be sold to a new co-owner.
Do I Need a Buy-Sell Agreement for My Business?
Small businesses with two or more owners are the most likely to have buy-sell agreements. Potential changes in ownership are especially important for businesses in which the owners take an active role in day-to-day operations. While owners who play only a financial role in a company may be less concerned with its future, owners who have a hand in the company’s management should have a strong interest in having a buy-sell agreement.
One of the main provisions of most buy-sell agreements requires that the remaining owner or owners purchase the interest of another owner who exits the company for whatever reason. The loss of an owner can cause hardship to a company, and a buy-sell agreement can prevent the company from the additional losses that come with costly disputes over how to move forward when an owner exits.
Another type of agreement that can prove useful is an insured buy–sell agreement. It represents a strategy that is often recommended by specialists in business-succession and financial planners to ensure that the provisions of buy–sell arrangement are funded, so that money is available when a buy-sell event takes place.
One type of insured buy-sell agreement is called the “cross purchase plan.” In a cross-purchase arrangement, each owner purchases a life insurance policy on the other owner or owners. Each owner pays the annual premiums on the policy they own and each is the beneficiary of the policy. When an owner dies, the surviving owners receive the death benefit from the life insurance policy they had on the deceased owner.
They then use the life insurance death benefit to fund the purchase of the deceased owner’s share of the business from the owner’s heirs. If there are a large number of owners of the business, each owner needs to purchase a policy.
Another type of insured buy-sell agreement is known as the “entity redemption plan”. In this plan, every owner agrees to sell their respective interest to the business in the event of a triggering event, e.g. the owner dies. The business purchases separate life insurance policies on the life of each owner and pays the premiums.
The business itself, not the owners, is the owner and beneficiary of all the life insurance policies. When an owner dies, their share of company stock, or other ownership interest in the business, passes to their heirs or their estate, and the company may purchase it with the proceeds from the life insurance policy.
Another option is a hybrid plan that combines the cross purchase and the entity redemption plans. In the hybrid plan, each owner is required to offer their interest to the business if they should want or be forced to exit. If the business declines the offer to sell it or cannot make the purchase, then other co-owners or partners can purchase the shares or interest in the business. The buy-sell agreement can have a provision that allows certain employees, or other specified people to purchase the interest that is being sold.
The type of business involved is not important. A buy-sell agreement can be tailored to any type of entity, whether it is a corporation, a partnership, a limited liability company, or even a sole proprietorship. A buy-sell agreement can work for any of these entities. Business specialists and financial planners often recommend an agreement that involves life insurance to ensure the funding that a buy–sell agreement requires. The insurance provisions guarantee that the funds are available to purchasers if the buy–sell triggering event comes to pass.
Life insurance proceeds are commonly paid quickly after the death of the insured person. Plus, the proceeds are usually paid quickly after the covered person’s death. And if sufficient cash values are available within the policies, the funds can be accessed to purchase a deceased owner’s interest in the business if they retire or become disabled. Also, the life insurance policy proceeds are typically not subject to income tax regardless of who owns the policy.
The goal is to control the orderly transfer of business interests when certain specified events occur. A buy-sell agreement:
- Creates a market for the interest of the owner who is exiting the business when there would not be a market without a buy-sell agreement;
- Prevents interruption in management and voting control of the business;
- Provides stability for the business for remaining owners and employees;
- Ensures that the survivor of a deceased owner can be adequately compensated for the deceased owner’s interest in the business;
- Enables surviving owners to purchase a deceased owner’s share right away, avoiding probate and the possibility of a personal representative of the deceased becoming a voting owner;
- Establishes an agreed-upon value for the purchase of an owner’s interest, eliminating the possibility for expensive and time-consuming litigation.
- Clarifies each owner’s interest in the business.
Should I Contact an Attorney If My Business Needs a Buy-Sell Agreement?
A corporate attorney will be able to help you draft a thorough buy-sell agreement that meets the needs of your company. Whether you are interested in protecting the future of your company by creating a buy-sell agreement, or if you already have one, an attorney with business experience will be able to preserve your rights and protect the stability and longevity of your company.