Buy-Sell Agreements - A Necessity for Business Owners
A well-advised business owner diligently plans and scrutinizes almost every key aspect when starting their business. This includes planning related to entity selection, marketing, taxes, legal, development and growth, in an effort to better understand risks and prevent surprises.
This article addresses the careful planning required for the survival of the business when any of the 4 D’s occur: Divorce, Disability, Death, or Departure (forced or voluntary). Each of these D’s is considered a “life event” as it relates to business ownership.
When starting your business, many partners are focused on development and are looking toward the business’s future growth. While commonly overlooked, part of that forward-looking perspective should include discussing what happens in the event any partner (shareholder or member, for example) is no longer able to serve in his/her original capacity (due to death, disability, retirement or voluntary/involuntary termination) or the partner experiences a significant change in their life (such as divorce or insolvency).
In order to plan for these life events, the partners must contract with one another through what is commonly called a Buy-Sell agreement. This contract is a way for the existing partners to control who they are partnered with, and to ensure that the families of the existing partners are taken care of in the event of death or disability. The Buy-Sell agreement can also protect the financial health of the business, so that it is not negatively affected by a buyout requirement.
Without a Buy-Sell agreement, there are generally no ground rules for what happens when a "life event" occurs. While there are common elements in most Buy-Sell agreements, each agreement must be individually tailored to the partners’ unique needs and circumstances.
In order to prepare a Buy-Sell agreement based on the distinctive needs of a relationship, the partners must answer some difficult questions that explain the ground rules, including questions related to purchase price, terms, and funding arrangements.
Questions to Ask When Preparing a Buy-Sell Agreement
- What situations or circumstances trigger the requirements of the partners to buy or sell?
- These are often referred to as “triggering events.” In a Buy-Sell agreement, common triggering events include death, disability, divorce, bankruptcy, offers of third-party sales or voluntary/involuntary termination.
- Once there has been a triggering event, who has the right to buy interest, and who has the obligation to sell?
- Typically, those experiencing the “life event” would have the obligation to sell, while those with the right to buy may include the company, the existing partners (not necessarily in that order), or even outside third parties as well.
- How will the price of the interest be determined in a Buy-Sell agreement?
- Generally, the partners could stipulate to the interest value (on an annual basis for example), use an existing accountant, or hire independent appraisers or valuation professionals. The method used may also depend on what type of assets the company owns, such as real estate, or if the company is an operating business.
- Once the price has been determined, how will the buyer pay the purchase price?
- Some of the more common payment methods include life insurance proceeds, cash, installment agreements, traditional loans, or a combination of methods.
- Finally, when will the Buy-Sell take place?
- This is typically called a “closing” and is related to the timing of the triggering event.
Final Thoughts - Reasons to Review Your Buy-Sell Agreement
Even when partners have completed the steps of discussing, preparing and adopting a Buy-Sell agreement, their job is not done. As the business and circumstances of the company and partners may change over time, the Buy-Sell agreement should be reviewed to make sure it reflects the current needs of everyone involved.
The Buy-Sell agreement should be revised to reflect a variety of changes, such as: changes in the business circumstances; changes in the owners’ health or personal lives, changes in the value of the business; how the purchase price is paid; and changes in the law.
Reviewing existing Buy-Sell agreements ensures that the agreement properly reflects the current intentions of the partners and allows for the continued viability of the business when a “life event” occurs.
Published May 2, 2018; Reviewed October 1, 2018