The last thing a happily married couple wants to think about is the possibility of a divorce. Similarly, partners launching a business rarely consider a day when one of them is no longer part of the picture. Eager entrepreneurs focus on steering a startup through its first few treacherous years, not realities that might be decades away.
Yet a jointly held business without a clear plan for ownership succession amounts to a series of contentious legal battles waiting to happen. A buy-sell agreement gives business owners the peace of mind of knowing that the company will never fall into the wrong hands.
What Is a Buy-Sell Agreement?
In broad terms, a buy-sell agreement (sometimes called a buyout contract) is a binding contract that specifies the circumstances under which an owner’s share of a business may (or must) be sold, and who may purchase that share. This document should be drafted as soon as possible after the business is founded.
Without such an agreement in place, decisions about who may assume ownership of the business will be left in the hands of probate courts, bitter ex-spouses, or others who may not have the best interests of the company at heart.
Key Sections of a Buy-Sell Agreement
Because it is impossible to predict the future life events of business owners, a buy-sell agreement must cover a broad range of scenarios.
To avoid legal headaches later, the contract must explicitly address at least the following critical issues.
1. Triggering Events: Under What Circumstances Can/Must a Sale Occur?
A triggering event is any occurrence that all owners agree should activate the ownership transfer process described in the buy-sell agreement. Typical triggering events include:
- Death or permanent disability of an owner. A buy-sell agreement supersedes any personal trust or will, stipulating that the deceased or disabled owner’s share of the business must be sold to other owners, rather than passed on to heirs.
- Divorce. In itself, an owner’s divorce should not trigger a buyout. However, a thorough buy-sell agreement gives other owners the right to buy out any ownership share awarded to an ex-spouse in a divorce settlement.
- Bankruptcy, criminal activity, or other threats to the business. A single partner’s bad decisions should not jeopardize the company’s existence. A buyout contract can specify circumstances under which a partner must sell his or her share to protect the business from the consequences of a personal tragedy.
- Retirement, voluntary departure, or conflict. In addition to ensuring that the business carries on without disruption if one owner chooses to step away because of advancing age or a desire to pursue other interests, the agreement should clearly specify buy-sell requirements if irreconcilable differences arise between owners.
2. Who May/Must Buy the Departing Owner’s Share?
In most cases, when a buy-sell requirement is triggered, other owners of the business must purchase the vacating owner’s share of the company. For a business that is 100% owned by one individual, the agreement designates another individual who has the exclusive right to buy the business when a triggering event occurs.
3. How Will the Value of the Ownership Share Be Determined?
There is no greater source of potential problems in enforcing a buy-sell agreement than disputes over the value of the business. The agreement must clearly state how that value will be determined. In most cases, the surest way to avoid conflict is to stipulate that a professional appraisal must be completed by a designated third party.
4. How Will the Buyout Be Funded?
All the potential benefits of a solid buy-sell agreement will go up in smoke in an instant if the designated buyers cannot assemble the resources needed to make the purchase. Many buyout contracts require owners to take out life insurance policies on each other to ensure that funds are available for a buyout; others allow installment purchases. In any case, the agreement must create a mechanism to ensure that the sale can be completed as intended.
In short, a handshake and a few scribbled notes on a bar napkin do not a buyout contract make. To avoid costly legal disputes over language and terms, enlist the help of a qualified attorney and business financial advisor when drafting a buy-sell agreement.
Types of Buy-Sell Agreements
Apart from variations in specified triggering events, valuation methods, and funding methods, buy-sell agreements differ with regard to whether the vacated ownership share is purchased by other individual owners or by the business entity itself.
Contracts based on the business buying the ownership share, known as entity redemption buy-sell agreements, can be simpler for businesses with large ownership groups. However, agreements based on individual owners purchasing each other’s shares—cross-purchase plans—often offer tax advantages, since the remaining partners receive a stepped-up cost basis for their ownership. Large businesses often use a hybrid of these two buyout structures.
In the case of a business that is 100% owned by one individual or a business with one majority owner, a one-way buy-sell plan may be employed instead of an entity redemption or cross-purchase plan. Under a one-way agreement, there is no requirement for the sole or majority owner to buy out other shares, since such shares either do not exist or cannot threaten his or her control over the business. Instead, the agreement only specifies who will purchase the business or the majority share upon the principal owner’s departure—usually a minority owner, heir, or favorite employee.
The Importance of Keeping the Agreement Up to Date
Creating a buy-sell agreement is not a set-it-and-forget-it proposition. Ownership transfers and business valuation methods that made sense five years ago may be completely inappropriate today. To avoid unpleasant surprises when a triggering event occurs, a buy-sell agreement should be thoroughly reviewed by all owners and their legal advisors at least once every several years, and updated as necessary.
Your Business and Its Succession
A battle over ownership succession casts a shadow over a business, denying owners the opportunity to reap the benefits of a lifetime of hard work. Planning ahead with a thoughtful buy-sell agreement ensures that a business dream never turns into a legal nightmare.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
As one of the most knowledgeable and well-connected tax & accounting professionals in the world, Harvey Bezozi's mission as a CPA and CFP ® is to provide concierge-level work product and service, along with seamless communication, high energy, and a super-positive attitude. Located in Boca Raton, Florida, Bezozi has been in business since 1994, and serves clients in all 50 states and internationally. More information can be found at YourFinancialWizard.com
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