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The Importance of a Buy-Sell Agreement

The Importance of a Buy-Sell Agreement

When you’re starting a new business venture with new partners, you tend to think about financial contributions, roles that each partner will play, and how you will work together to make the business succeed. You’re usually not thinking about the eventual end of the business because you figure you’ll have 20 years or so to worry about that later. But we encourage you to begin with the end in mind, and make a buy-sell agreement part of your start-up documents!

What is a Buy-Sell Agreement?

A Buy-Sell Agreement is a written agreement among the owners of a business in which each owner agrees that upon the occurrence of a specified event (death, disability, termination of employment, etc.), his or her shares will be sold to the surviving owners at a specific price, and each owner commits to buy the shares of their departing co-owner when that time comes.

There are several reasons a good buy-sell agreement is important to you:

  • A valid buy-sell agreement will protect you and your family.
  • If you retire or become disabled, your chosen successors will buy your interest at fair market value.
  • If you die while owning the business, a buy-sell agreement can guarantee a buyer and a predetermined price for your heirs.
  • A buy-sell agreement negotiated between you and an unrelated successor provides a valuation that you can generally rely on for gift and estate tax purposes.

Types of Buy-Sell Agreements

There are generally three different types of buy-sell agreements:

  • Cross-Purchase Agreement: A cross-purchase agreement allows the remaining co-owners to purchase the interest of a departing owner. Each co-owner must have sufficient capital to make the purchase. For the death of an owner, each owner generally acquires a life insurance policy on the lives of each other owner, and the death benefits received are required to be used to purchase the deceased owner’s interest.
  • Entity (or Redemption) Purchase Agreement: An entity purchase agreement requires the business to purchase the interest of a departing owner. After the purchase, the remaining owners would be the only owners of the entity. It is also common to fund the purchase with a life insurance policy purchased by the business.
  • Hybrid Agreement: A hybrid agreement provides the remaining owners and the business itself to purchase the interest of a departing owner. With a hybrid agreement, it is possible to give the individual owners the right to acquire the interest, but not the obligation. If the owners decline, the business would be obligated to acquire the interest of the departing owner. Alternatively, the agreement may allow for both the remaining owners and the company to purchase the departing owner’s interest. Therefore the hybrid agreement has characteristics of both the cross-purchase and the entity-redemption agreement and is the most flexible.

The valuation section of a buy-sell agreement is very important because it defines how the value of the owner’s interest will be valued when there is a change in ownership. The method of valuation must be clearly defined. A method should be selected that determines current fair market value at the time of the triggering event. Vague language for a formula that establishes a range of prices, rather than a firm price should be avoided. The reason is that two valuation professionals using vague language may calculate two very different values, either of which is within the range.

Funding a Buy-Sell Agreement

Buy-Sell Agreements can be funded (usually with life insurance) or unfunded (usually with promises to pay). Funding a Buy-Sell Agreement with life insurance is usually the most practical method – the heirs get cash and walk away, and the surviving owner gets the deceased owner’s shares immediately. Unfunded Buy-Sell Agreements are usually better than no agreement, but the odds of the heirs ever getting paid are relatively low. Quite often the earnings are not sufficient to pay off the heirs.

Finding a Successor

If a company has only one owner, it’s up to that owner to find a successor and enter into a buy-sell agreement. Sometimes the successor will come from the next generation of the family.

When there is no related heir apparent and no co-owners, finding a successor can be difficult. A key employee might be designated. Or the owner of a successful medium-sized company or professional practice might actually acquire a smaller firm headed by a younger individual, in the hope that the prime mover behind the acquired entity will someday take over the larger firm. In any event, a buy-sell agreement should be in place between the current owner and the designated successor.

Buy-Sell Agreements and Multiple Shareholders

In a company with two or more major shareholders, a cross-purchase buy-sell agreement will generally be among the co-owners. The same is true in a professional practice with multiple principals or partners. If the buy-sell agreement is an entity-redemption agreement or a hybrid agreement, the agreement will be between the owners and the entity (company).

A buyout agreement may require surviving owners or successors to pay a lump sum or periodic installments when a triggering event occurs. The choice of payment will often vary, depending on the nature of the triggering event. Buyouts that require a lump sum payment are likely to be funded with life insurance or lump sum disability insurance, if it can be obtained.

Under an entity-redemption agreement, the company buys and is the beneficiary of an insurance policy on the life of each business owner. Each policy is for the amount needed to buy that owner’s interest. In a reciprocal cross-purchase agreement, each party buys and is the beneficiary of a policy on the life of each of the other owners for the amount that is their pro-rata share of the buyout price.

Assume a hypothetical $1 million business with two equal owners. With an entity-redemption buyout agreement the company will buy, and be the beneficiary of, a $500,000 policy on each owner’s life. In a cross-purchase plan, each owner will own and be the beneficiary of a $500,000 policy on the other owner’s life. Obviously, the cross-purchase plan becomes more complicated as the number of owners is increased.

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