Small Business Advice

What is a buy-sell agreement?

An effective buy-sell agreement may guarantee business continuity and protect your interests in your absence. Learn what this important document does and how you can use it for estate planning.

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Even though 60-70% of small business owners wish to pass along their companies to younger generations of family members, only 15% of them have a succession plan in place1. As an entrepreneur, there’s a possibility that you’ve never contemplated what should happen to your business in case you retire, or (worst-case) become disabled or die.

The same may be true for partnerships. What happens if your partner moves on permanently? What if they die, become incapacitated or are declared bankrupt? Either of these possibilities will result in significant changes in the ownership and management of the business.

Without an air-tight buy-sell agreement, the business and its surviving owners may face major financial, legal and tax problems. On the other hand, a well-designed buy-sell agreement may anticipate and address such questions, making it easier for the company to implement a fair and practical succession plan. That is why owners of a business are usually advised to create a buy-sell agreement from the outset.

But what is a buy-sell agreement and how does it work? This article answers those and many more questions, including how to prepare a good buy-sell agreement for your business.

Key takeaways

  • A buy-sell agreement is a legally binding document that describes how a business owner’s interest may be reassigned in case of their death, disability or retirement from the business.
  • A buy-sell agreement is necessary primarily because it ensures business continuity and protects your interest in the business.
  • buy-sell agreements typically establish a reliable method for calculating the value of the business.
  • The most common types of buy-sell agreements are cross-purchase and redemption agreements.

What is a buy-sell agreement?

A buy-sell agreement is a legally binding document between a company and its owners stipulating how business interests should be treated in case of a significant event such as the departure, bankruptcy or death of one of the owners.

Such events usually have a big effect on the control and management of a business. Without a clearly written buy-sell agreement in place, there may arise conflicts between business partners if one or more wish to sell their interest in the business and focus on something else, or if they are forced to dispose of their stake owing to bankruptcy proceedings.

The same may happen if one partner dies. Surviving owners can find themselves locked in a tussle over who will inherit the deceased’s shares and who will assume the management roles they played. A buy-sell agreement anticipates such conflicts and preemptively assigns roles and distributes shares. Oftentimes – but not always – the agreement will stipulate that any available shares be sold or distributed between the remaining partners in pre-stated proportions.

Some triggering events that may activate a buy-sell agreement include:

  • If an owner resigns from the business
  • In case one owner is terminated from the business
  • An owner decides to retire from the business
  • Married owners divorce
  • One or more owners are declared bankrupt
  • An owner is permanently disabled or incapacitated
  • An owner passes away

Since it anticipates what should happen if business owners “break up”, a buy-sell agreement is also known as a business prenup, business will, buyout agreement or simply buy-sell agreement.

How does a buy-sell agreement work?

A buy-sell agreement works by clearly stipulating how the transition of ownership should be handled in case a business owner or partner is incapacitated, deceased, or permanently leaves the business. This document typically requires that the exiting owner’s shares be sold either to the business itself or to the remaining partners in a predetermined formula. If the trigger event is death, the deceased’s estate is legally obligated to sell his/her shares.

buy-sell agreements are common among sole proprietorships, partnerships, and closed corporations. Their primary function is to ensure a smooth transition in case an owner dies, is incapacitated, retires or opts to leave the business. In doing so, these agreements help business owners to properly and easily manage a potentially challenging situation in ways that not only protect the business, but also its owners and their families.

Many of these agreements have transfer restrictions. Generally, an owner or shareholder doesn’t have the ability to freely transfer or sell their stake to an outsider. The reasoning is that remaining partners wouldn’t want to take up just anyone as a substitute. For that reason, many buy-sell agreements usually give the business itself and its remaining shareholders priority over a withdrawing partner’s shares. This is called a right of first refusal, where the company and remaining co-owners have the first right to acquire available shares. It’s only when they are unable to pay for those shares that they may consider bringing in a new (substitute) partner.

That said, buy-sell agreements can give exceptions to transfer restrictions that don’t trigger any right of first refusal. For example, many of them allow transfers to direct family members and revocable trusts. Nonetheless, this restricted transfer is different from public companies, where shares are traded freely in stock markets.

Why have a buy-sell agreement?

A buy-sell agreement is necessary primarily because it facilitates a smooth and orderly transfer of business interests, particularly when triggering events happen. Without this document, several plausible scenarios may play out.

For example, a bank or other lender might end up having shares in the company on account of a partner’s debt. A former partner’s spouse could become a co-owner in the business, despite having absolutely no knowledge about its activities. Their family members may get seats and voting rights.

Ultimately, a buy-sell agreement prevents eventualities that shouldn’t happen from happening. It effectively describes under what circumstances a business may sell a bankrupt, retired or deceased owner’s interest, whether or not remaining owners can buy that interest, how much they should pay for it, and who they can admit into the business as a substitute for the departing or deceased owner.

Here is a more detailed look at why it’s important to have a buy-sell agreement:

  1. It establishes a fair market value for company shares

A buy-sell agreement sets a fair value for an owner’s share in the business, particularly if there is no other agreement that establishes such value. In other words, the document helps business owners to understand how much stake each one has in the company.

By determining these figures ahead of time, a buy-sell agreement prevents possible valuation conflicts when one partner wishes to sell their shares and exit the business. Everyone will know exactly how much their shares are worth.

  1. Creates a market for a departing owner’s shares

Selling private shares can be difficult because they are usually less liquid compared to public shares2. As such, a departing owner may find it hard (or even impossible) to dispose of their interest in a business should they want to retire or move on. Plus, remaining owners don’t always want to bring in substitute partners, which makes it even harder to sell a departing owner’s stake.

A buy-sell agreement can solve this problem by specifying who the shares should be sold to. As a buyout agreement, this document typically gives remaining owners priority over a departing owner’s interest. However, it may also specify otherwise. For example, the agreement can allow the transfer of shares to family members, especially if the departure is caused by death.

  1. Allows surviving owners to keep business interests

As already mentioned, the absence of a buy-sell agreement opens the door for unexpected new partners. A bank can claim some company shares on account of a deceased owner’s debt. Their family members can claim seats and voting rights in the company.

But if the business has a buy-sell agreement, it will allow surviving owners to purchase and keep the deceased’s interest, thus ensuring it doesn’t end up in the wrong hands.

  1. Acts as an exit plan for business owners

Like all human relationships, business partnerships can have messy endings. Without an airtight buy-sell agreement, partners may fail to agree on important terms during the break up. But with such a document in place, you will have fewer headaches as well as minimal financial and legal risk because it spells out the terms and conditions that every partner should abide by. Think of it as a prenup that protects your interests in the event that your marriage doesn’t work out.

  1. Ensures business continuity

One overlooked importance of a buy-sell agreement is that it helps you plan for your own triggering events ahead of time. If you are a major owner in the business, your permanent absence – especially due to incapacitation or death – can cause extreme disruptions as people fight for control and management. This can easily tank the business.

A good way of preventing such a scenario is creating a buy-sell agreement that clearly states what happens to your interests in case of your permanent absence. Otherwise, if you don’t plan for such an event in advance, you’ll essentially be leaving the decision to lawyers.

How to determine the purchase price

Besides ensuring a smooth transition in ownership, a buy-sell agreement also spells out the valuation methodology to be used when appraising a partner’s share. This can be helpful when there’s a dispute regarding the value of the business and each owner’s stake. In such a case, the valuation methods stated in the buy-sell agreement would be used before or during arbitration.

Perhaps more importantly, a buy-sell agreement can be used to set the price of an owner’s interest in a business. As already mentioned, one of the things that this binding contract does is describe the valuation methods to be used to appraise the business as well as each owner’s interest. This is usually done beforehand when each owner doesn’t know whether they will be on the buying or selling side. It creates a neutral environment for determining the value of the business and the purchase price for each owner’s interest.

The typical buy-sell agreement will describe this purchase price as a “fair market value”. According to the IRS, a fair market value may be determined based on factors that include3:

  • Nature and history of the company
  • Financial position of the business
  • Economic outlook and industry trends
  • Book value of the shares in question
  • Market price of similar shares
  • Revenue capacity of the business
  • Net profitability of the company
  • Presence of goodwill and other intangible assets

Of course, partners and shareholders can set their own criteria for determining the value of the business. In which case, there are several approaches to keep in mind:

  1. Using a valuation formula: shareholders can agree upon a valuation formula to be used when calculating the price of the owner's interests. Whether it’s based on business earnings (like EBITDA and SDE) or the raw book value of the company, a valuation formula may provide an objective way to determine the value of an owner’s interest.
  2. Appraisal: business owners can each or collectively hire the services of an appraiser to determine the total worth of each owner’s interest. Experts who offer such services include CPAs and professionals in estate planning.
  3. Valuation by mutual agreement: this approach is quite subjective because it depends on owners reaching an agreement on how much they think the business is worth. you basically sit down with your co-owners and come up with a value after debate.
  4. Silent auction: this is not valuation as much as it is an auction. When a co-owner exits the business, the remaining owners set forth the price at which they are willing to buy the newly available shares – often through a secret ballot. The person with the highest bid acquires the interest of the leaving partner.

Needless to say, using a professional appraiser or a valuation formula will yield the most objective and accurate result.

Types of buy-sell agreements

There are three main types of buy-sell agreements: 1) the cross-purchase agreement, 2) the redemption agreement, and 3) the hybrid agreement.

Cross-purchase buy-sell agreement

This is a buyout agreement where remaining shareholders are obliged to purchase the shares of a partner when a triggering event happens. Cross-purchase agreements are typically hinged on life insurance policies.

This is generally how it works: the business acquires life insurance policies on the lives of its owners. The face value (or death benefit) of each owner corresponds to their interest in the business. And if an owner dies, the business claims the benefit and uses it to buy out that deceased owner.

Say, for example, that the value of your interest in a partnership business is $850,000. Your company would take a policy on you worth $850,000 from a life insurance company. If you pass away, the surviving owners would take the life insurance proceeds and use them to buy you out of the business.

Needless to say, the business will have to pay higher premiums as owners’ equity grows. But that’s not usually the biggest problem with a cross-purchase buy-sell agreement. Its biggest drawback is that the dollar amount payable in premiums grows exponentially with an increasing number of shareholders.

If there are only two partners, then each partner will take a policy on the other. That means the business will only have two life insurance policies to pay premiums for. If there are four partners, each partner will take a policy on the other three. Thus, there will be a total of 12 policies that the business has to sustain.

For illustration purposes, assume the four partners are named A, B, C and D. Partner A would have three policies (on B, C, and D). Similarly, partner B would have three policies (on A, C, and D). C and D would also have three policies each, bringing the total number of policies to 12.

Each additional owner will increase the number of policies. And this is what can make the cross-purchase buyout agreements costly. However, depending on the life insurance company you choose, you may be able to create a trust or separate entity that will purchase life insurance policies on behalf of the primary business. Just make sure that the second entity fully complies with the terms and conditions of the buy-sell agreement.

Redemption Agreements

Under this type of buy-sell agreement, the business is obligated to purchase the interest of the departing or deceased owner. It differs from a cross-purchase agreement in that the latter gives remaining owners the right to buy out an exiting partner while a redemption agreement gives the company itself (not remaining owners) that right.

The company is typically granted the right of first refusal for third-party offers on the available interest. Thus, if a shareholder dies or is incapacitated, their shares are returned to the company for payment based on the terms laid out in the buy-sell agreement.

Redemption agreements are usually funded with disability or life insurance policies, whose premiums are paid by the business itself. This means that the business is the policy holder and thus the beneficiary. When a triggering event occurs, the business collects a payout from the life insurance company and uses it to compensate the leaving partner (or their beneficiaries) as per the buy-sell agreement.

One disadvantage of using a redemption buy-sell agreement is that it can put a strain on the business’s cash flow. The money used to finance the life insurance policies of shareholders comes from the business. This reduces the funds available for other business activities.

Hybrid Buy-Sell Agreements

Also known as a wait-and-see agreement, a hybrid buy-sell agreement provides options for the business and remaining shareholders to acquire ownership interest of a withdrawing partner. Some hybrid agreements require that the shares be offered first to the business and then to remaining shareholders in case the business is not able to complete the entity-purchase. Other agreements prioritize shareholders, allowing them to redeem the shares of a departing partner. If they are not able to, then the business is allowed to acquire those shares.

Hybrid buy-sell agreements are typically used when there’s no life insurance on the disabled or deceased partner. This may happen if such a partner is uninsurable. Nonetheless, a hybrid agreement provides flexibility since it may give both the corporation and its shareholders the opportunity to buy out a withdrawing partner.

A drawback of this agreement is that life insurance policies on shareholders are not owned by the business. Therefore, the monetary value on them cannot be categorized as business assets.

Before you settle on who will fund a buyout, it’s important to keep in mind that certain conditions may increase the income tax liability associated with the purchase. For example, under a redemption agreement, there may be a trigger in corporate level gain on account of appreciated property. This may attract an income tax. Similarly, if you use a cross-purchase agreement, you will incur income tax because you will be using the death benefits of a life insurance policy to purchase the available shares.

Therefore, before you settle on a particular type of buyout agreement, make sure to understand its consequences as far as income tax liability.

Buy-sell agreement checklist

All effective buy-sell agreements cover the same basic issues, including valuation, right of first refusal, and tax provisions for family members who may inherit the shares of a deceased owner. That said, buy-sell agreements are just that – agreements. Therefore, if you have co-owners, make sure to hold robust and conclusive discussions with them until you all agree on the terms and conditions of your buy-sell agreement. Here are some important things to deliberate and include in the document:

  • The nature and owner(s) of the business, including their beneficiaries.
  • The nature and type of buyout agreement. If a triggering event happens, is the business obligated to redeem the available shares or should co-owners be obliged to buy them? There can be a hybrid system in place as well.
  • Management team, including board of directors and top managers. Remember to specify whether or not the business has outside managers and directors.
  • Business continuity. This part addresses how the company will continue operations in case a triggering event occurs. Apart from ownership changes, it should also cover key employees and directors who have no shares in the business.
  • With regards to a departing co-owner, the agreement needs to address their compensation package, non-compete, non-disclosures, and their rights and protection with regards to intellectual property and intangible assets.
  • Dispute resolution techniques among owners, such as mediation and arbitration.
  • Events that may trigger a buyout and activate the buy-sell agreement. Some common events include death, incapacitation, disability, retirement, bankruptcy, divorce, and termination of employment.
  • Whether or not exiting partners can sell their interest to non-owners. This brings the right of first refusal into context.
  • Restrictions and provisions regarding new equity. Is the company allowed to dilute its shares or are there anti-dilution provisions?
  • Does the activation of a buy-sell agreement result in the restructure of the business? This is particularly necessary in an S-corp because the exit of one shareholder may change the S status.
  • Valuation methods to be used when determining the total worth of interest.
  • Terms of payment. You can indicate whether or not the buying party is allowed to make installment payments.
  • Insurance policies taken on the owners to cover share transfer in case of a trigger event. These may be term or life insurance policies, but the latter are more common.
  • The tax effect of share transfer. Such taxes include income taxes, estate taxes and capital gains.
  • Is the buy-sell agreement fully compliant with securities laws or common business law?

Obviously, a buy-sell agreement is quite an extensive document that will possibly cover a lot more than the above. In case you are not sure what to include, try bringing in a lawyer who may help create an effective and binding contract. You can also get a CPA to go over the numbers and ensure that they make sense.

As a co-owner, you’ll generally want to understand whether the agreement allows you to sell your interest for cash. You should also have a document that offers you a satisfactory percentage of shares based on your contributions (capital and otherwise). If not, it should at least give you the chance to increase your interest in the future. Finally, the agreement should protect you from legal and economic exposure.

References

  1. Benjamin Gran. “All You Need to Know About Small Business Succession Planning.” The PNC Financial Services Group, Inc., 28 May 2022, https://www.pnc.com/insights/small-business/business-planning/all-you-need-to-know-about-small-business-succession-planning.html
  2. Alison Kimberly. “How to Sell Stock in a Private Company.” FinMasters, 3 April 2022, https://finmasters.com/sell-stock-in-a-private-company/
  3. Buchanan Law Group. “The Buy-Sell Agreement.” 15 May 2022, https://www.buchananlaw.com/the-buysell-agreement
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