Does your business need a buy-sell agreement?
One of the wonderful things about being an entrepreneur is the freedom it affords. Sure, it can also be stressful, challenging, and even overwhelming at times, but for many business owners, this is a fair trade-off for the opportunity to choose what you do, where you do it, and perhaps most importantly, who you do it with. Entering into partnerships, in whatever legal form they may take, is one of the most important decisions an entrepreneur can make. Business people are typically familiar with the common agreements used in a business – an operating agreement, shareholders’ agreement, etc. However, often times, these agreements do not sufficiently cover issues pertaining to the partnership breaking up.
“Break-ups” can happen due to death, bankruptcy, or a partner simply desiring to leave. Ownership interests in a business can also be implicated in a partner’s divorce or other personal events. Usually, a departing partner’s interest in the business doesn’t simply disappear. Rather, without proper planning it could become the property of the departing partner’s heirs, creditors, or ex-spouse. This can result in the remaining partner(s) having to share in the business, and potentially its governance, with someone totally unknown or adverse to them.
Fortunately, these concerns can be addressed through a contract called a “Buy-Sell Agreement.” Essentially, a buy-sell agreement (sometimes called a “buyout agreement”) is a contract between the partners that governs what would happen with a partner’s interest in the business in the event of their death, withdrawal, bankruptcy, and other scenarios. The purpose of having a buy-sell agreement is to ensure that the remaining owner(s) are able to retain control of the business, while fairly compensating the departing partner and/or their heirs or creditors. Another way to think of a buy-sell agreement is that it’s analogous to a prenuptial agreement or even a “business will” for entrepreneurs – by planning for potential death, break-up or other event, having the rules in place ahead of time will save a lot of emotional, financial, and other head (and heart) ache down the road.
How does a buy-sell work?
Generally speaking, a buy-sell agreement creates mechanisms by which the remaining partner(s) may purchase the interest of the departing partner. These agreements typically include rules regarding the valuation of the business, what effect the nature of the departure might have on the buy-out amount, the rules for payment, and other important provisions. The type of buy-sell agreement described here is called a “cross-purchase agreement.” However, it is possible to structure these agreements as stock redemptions (where the company itself is involved, in addition to the partners), or as a combination of the two.
Where does the “buy-out” money come from?
At the heart of any buy-sell agreement is the question of money. Once a value is established for the departing partner’s share, what happens if the remaining partner(s) are not in a position to pay? Typically, this is addressed in part by the partners taking out life insurance policies on one another. As business partners, the parties have an insurable interest in the lives of each other. As such, so long as the partners’ life insurance policies are sufficient to cover the established amount of the deceased partner’s share, they can use the proceeds of these policies to effectuate the buy-out. Alternatively, and in cases of business divorce not occasioned by a death, it is common for partners to establish an installment payment plan or another arrangement that covers the possibility that a lump sum payment may not be feasible.
What is the process of creating a buy-sell agreement?
A buy-sell agreement can be a complicated endeavor, but that should not be a deterrent to creating one. Because this type of agreement implicates legal questions, business valuation considerations, and tax matters, it is imperative that business owners rely on their trusted legal, tax, and business advisors in creating an agreement. These professionals can take much of the work off of the partners’ plates, so that the partners can focus on the substantive questions concerning how they envision the date of their business, and what constitutes a fair agreement between them. This process brings to mind the old adage that one should “hope for the best but prepare for the worst.” Having a buy-sell in place, much like a will, can give business owners peace of mind, freeing them up to focus on the positive aspects of their business instead of worrying about an uncertain future.
For any additional questions, please feel free to reach out directly!