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Building a business is all about the day-to-day decisions. But what happens to the business if the primary decision-maker isn’t there? Creating a continuity plan that outlines transition planning should be part of the foundational documents of a business at any stage. Valuing the business, codifying the steps that will be taken and planning for transfer of ownership can help protect both the business and the interests of everyone involved – including family.
When partners start a company, they may document how to maintain its management and control if a partner dies, becomes disabled, or leaves the company. A well-designed, buy-sell agreement, or buyout agreement, is a legally binding agreement between co-owners of a business that stipulates the procedures if a co-owner dies, chooses to leave the firm, or retires.
An essential aspect of the contract is guidance about how a partner’s share of a business may be reassigned if that partner dies or leaves the business and establishes a fair value price for the shares. The buy-sell agreement also gives the co-owners of the business entity the option or obligation to purchase the interest from an existing owner to restrict outsiders or unsuitable or undesirable business partners from becoming owners. This option is often a valuable provision for family businesses.
Without these agreements in place, arguments can arise among partners or surviving spouses leading to the loss of valuable time, increased expenses, and expensive litigation.
The Nuts and Bolts of a Buy and Sell Agreement
Sole proprietorships, partnerships, and closed corporations generally adopt buy-sell agreements to establish procedures for ownership changes if a partner dies, retires, or leaves the business. Most experts recommend creating a buy-sell agreement soon after starting a business. Establishing it early ensures that the process is less fraught with emotion. Creating the document before your company has grown substantially means fewer assets to divvy up and fewer arguments.
Typically, buy-sell agreement terms oblige the remaining business partners to purchase the departing partner’s business shares at a fair value price according to a prearranged formula. Thus, a crucial part of the buy-sell agreement is a valuation provision. This clause will set the value of each partner’s stake in the company. Several companies include a valuation formula within the contract, such as multiples of book value or earnings, while other companies stipulate that a valuation expert will determine the company’s price when a partner’s share must be sold.
Effective buy-sell agreements address when and under what conditions a business may sell an owner’s interest. The agreement also states whether the other business owners can buy the interest from that owner before offering it to an outside party. Hence, the business interests remain with the surviving owners. In addition, the agreement will commonly describe whom the remaining owners will agree to be the new owner. Thus, the agreement serves as a business continuity plan and enables the company to continue to operate smoothly after a partner’s departure. If a partner passes away, the estate has the discretion to decide if it wants to sell.
Why Establish a Buy-Sell Agreement?
A buy-sell agreement assists in the orderly transfer of business interests when certain events occur. The agreement typically:
- Creates a market for the departing owner’s interest in the business (especially when there is no market for it without the buy-sell agreement)
- Prevents a break in management and the business’ voting control
- Creates job stability for the remaining minority owners and key non-owner employees.
- Ensures that the deceased owner’s heirs are compensated
- Enables surviving partners to purchase a deceased owner’s share quickly. Thus, preventing the deceased interest from being locked up in probate and preventing the deceased’s personal representative from becoming a voting owner
- Verifies each owner’s business interest
- Establishes an accepted value to purchase an owner’s interest, eliminating the chance of costly and time-consuming litigation
Understanding Buy-Sell Agreements
There are two common forms of agreements:
Many business partners choose to establish a hybrid version of these agreements, i.e., individual partners will purchase a percentage of the business up for sale, and the partnership will buy the remaining portion.
Business partners may also establish a funding mechanism to ensure a smooth transition when a partner exits the company. For example, purchasing life insurance for the partners is one way to ensure that funds are accessible if a partner dies or leaves the company. The business pays the premiums and is the policy’s owner and beneficiary in this situation. If a partner dies, the share of the company is bequeathed to the heirs of their estates. The company can use the policy’s death benefit to buy the interest from the estate. If a sole proprietor passes away, a key employee may be selected as a successor or buyer of the business.
Key Considerations in Buy and Sell Agreements
The purpose of buy-sell agreements is to help partners cope with potentially difficult situations that protect the business and their personal and family interests. For example, the agreement can specify that owners cannot sell their interests to outside investors without obtaining approval from the remaining owners. Similar protection can be stipulated in the event of a partner’s death.
A typical agreement might state that a deceased partner’s interest will be sold back to the business or remaining owners. As a result, the estate cannot sell the stake to an outsider.
In addition to controlling ownership of the business, buy-sell agreements describe how to assess the value of a partner’s share. These stipulations are crucial beyond the question of buying and selling shares. For example, if there is an argument between the owners about the company’s value or of a partner’s interest, the valuation methods spelled out within the buy-sell agreement would be used to settle the dispute.
Assessing the Benefits
A buy-sell agreement provides employers peace of mind knowing their business is in capable hands if they are unable to manage it.
Other benefits include:
- Provides funds to create a fair market value exchange
- Promotes equitable and orderly transfer of wealth, ownership, and management
- May offer tax advantages such as establishing a conservative value to the business
- Guarantees heirs a buyer for assets if they cannot manage it
- Provides cash to heirs to pay estate debt, expenses, and taxes
For partners, these agreements provide a way to purchase a business they have a personal stake in but may not have insufficient capital. It also assures the remaining owners that the deceased’s share of the business will not be transferred to someone unsuitable. The buy-sell agreement also provides continuity for customers, creditors, and employees.
Risks and Other Considerations
Partners must be diligent in updating the agreement regularly; otherwise, the terms may not match the owners’ current situation or future goals. Partners must remember that the company’s value is defined within the agreement. As a result, if the document is not updated regularly, there is a risk that a partner will not receive the correct price for their interest.
In the buy-sell agreement, partners should also include the value of corporate real estate holdings, which can be essential to business operations. If real estate is not included, it will not be subject to the terms of the buy-sell agreement and thus lowers the overall value of the enterprise.
Funding of the sell-buy agreement is also critical. If an insurance policy will be the source of the funds, it’s important to certify that the terms of the agreement match the terms of the insurance. If the insurance is not owned by the right executive or funded for the correct amount, it can cause financial and tax issues.
The Bottom Line
The purpose of a buy-sell agreement is to assist partners in managing potentially difficult situations while protecting the business and their own personal and family interests.
In addition to controlling ownership of the business, buy-sell agreements include instructions about how the value of a partner’s share will be assessed if he or she leaves the company, retires, or dies. Typically, a contract might specify that a deceased partner’s interest will be sold back to the business or remaining owners. The stipulation stops the estate from selling the share to an outsider.
A buy-sell agreement is an excellent tool to help business owners plan for today and tomorrow and to help avoid costly and time-consuming disputes which can cause financial and operational headaches.