Understanding buy-sell agreements

Tom Spilman //July 5, 2012//

Understanding buy-sell agreements

Tom Spilman //July 5, 2012//

What happens to your business if you or one of your partners suddenly dies or is disabled? What are your plans for the business when you retire? Or what if you become involved in an unresolvable disagreement with a partner about the future of the business?

As the owner of a closely-held business, you can know the answers to these questions and others by implementing a buy-sell agreement for your business. A buy-sell agreement is a fundamental component of your business succession plan, and can provide a smooth transition for your business when certain critical events occur. It can also ensure you preserve the wealth you have worked so hard to earn for you and your family.

What is a buy-sell agreement?

A buy-sell agreement is a contract among the owners of the business or between the owners of the business and the business entity itself. The agreement usually contains several standard provisions, including:

  • restrictions on the sale or transfer of ownership interests to others;
  • defining events that will “trigger” the sale or purchase of ownership interests; and
  • setting the price or a method for determining the price and terms of payment if shares in the business are sold.

Buy-sell agreements allow business owners to decide proactively who may own and operate the business and when an owner may liquidate his or her interest in the business. Buy-sell agreements should be flexible and anticipate situations where one owner’s best interests deviate from those of a partner.

A well-drafted buy-sell agreement can accomplish several estate planning and business succession planning objectives, including:

  • allowing the transfer of business shares to children, grandchildren and trusts for family members;
  • ensuring business ownership remains in the family by forbidding ownership by in-laws or outsiders;
  • planning for an owner’s death, disability, divorce or retirement;
  • setting the price and terms of payment when a transfer of business shares occurs or when the company redeems an owner’s shares, helping minimize disputes between owners and families;
  • providing the business with liquid assets to purchases shares from owners or their estates at the owner’s death or disability; and
  • creating a “market” for the business owner’s shares at death, providing liquidity to pay taxes and avoiding financial hardships for the family and business.

Three types of buy-sell agreements

There are two primary types of buy-sell agreements, as well as a third hybrid option.

  1. Redemption agreements: These types of agreements tend to be used when the business has three or more owners and the company wants to maintain a fairly tight control over the funding mechanisms.
  2. Cross-purchase agreements: These agreements can be executed in cases when the business has two or three owners, and in many cases, each is required to own a life insurance policy on the other owner(s).
  3. Hybrid agreements: These agreements contain features of both the redemption and cross-purchase agreements.

The cornerstone of estate planning for business owners

Buy-sell agreements are contracts and can easily be modified or amended through agreement among the interested parties. This becomes important when a business takes on additional owners or takes on owners outside of the original family or families involved. A company’s buy-sell agreement may need to be reviewed when changes occur in the business’s value, the industry in which the business operates, or the appropriate valuation methodologies for the business and industry. The funding arrangement for the buy-sell agreement must also be closely monitored.

The buy-sell agreement is often the cornerstone of a business owner’s estate plan. It can provide for lifetime and testamentary transfers to family members of several generations either outright or in trust. Transfers or sales of business interests to irrevocable trusts—as a buy-sell agreement typically permits—may enhance a client’s asset protection and tax minimization goals.

However, most business owners do not want other owners to transfer their shares to anyone and everyone at their discretion. The relationship between the cofounders of a business, for example, is often unique, and the desire to work together in a business may not extend to the cofounder’s ex-spouse, brother-in-law or other relatives. Transfers that could jeopardize a company’s S corporation election should also be prohibited. Therefore, buy-sell agreements usually contain some reasonable restrictions on the transferability of the stock, particularly involving those outside the bloodlines.

Triggering events

One of the most important features of a buy-sell agreement is identifying the “triggers” that may cause provisions of the agreement to be implemented, such as death, disability or incapacity, divorce, departure or retirement, disputes, bankruptcy or insolvency, and transfers to an unauthorized owner.

When a trigger occurs, the buy-sell agreement addresses how the company or other shareholders purchase the shares of the owner who has experienced the triggering event. The trigger may activate a mandatory or optional purchase of shares between parties, depending on the circumstances.

If there is a desire to continue ownership within a family, the buy-sell agreement may not institute a mandatory purchase of an owner’s shares at death. Instead, the estate of the deceased owner may have the option to sell its shares at a specified price to the company. When continued ownership with a surviving spouse or younger family members is not agreed upon, the buy-sell agreement might require the estate to offer its shares for sale back to the company. Or the company might have the option or might be required to buy the shares, depending on the terms of the agreement.

Purchase price and terms of payment

The purchase price and terms of payment are probably the most important features of a buy-sell agreement. The price—or the valuation methodology—should be established in the early years of the business before owners begin to identify themselves as likely buyers or likely sellers under particular trigger scenarios.

The three basic ways to determine the purchase price under a “buy-sell” agreement are:

  1. periodic agreement to a fixed price by the owners;
  2. some formula, usually tied to a capitalization of earnings, book value or a combination of these methods; and
  3. a professional appraisal.

The buy-sell agreement should also establish the terms of the payment to the seller. It may be difficult or impractical given business cash flow to pay the purchase price in one lump sum, so some form of installment payments are often necessary. The ability of the company or continuing shareholders to make a down payment on the purchase of shares—let alone a lump sum payment—will depend on the available funding when a particular trigger occurs. For triggers like death, disability or retirement, life insurance can play a critical role in funding the buyout of the exiting owner.

Recognizing and preparing for contingencies in your business before they occur can ensure a more harmonious business relationship among business owners, as well as a more secure financial future for you and your family.