People put together a will so that there is a plan in place for the future after they pass on. But what about businesses? What happens when a business partner dies or moves on?
Businesses can plan and protect themselves with a buy-sell agreement. Let’s take a look at what these are and how they work.
An easy definition of a buy-sell agreement: it is like a business will. These agreements are used by the owners and partners of a company to spell out what happens to the business should a partner die, leave the business, or retire. Sole proprietorships, partnerships, and limited liability corporations (LLCs) can benefit from having buy-sell agreements in place.
Buy-sell agreements are legally binding contracts. Ideally, they are drawn up and agreed upon by both parties. It is wise to use a contract lawyer, accountant, and business valuation expert to help craft the agreement.
Some key areas that an agreement will address include:
● identification of parties involved
● the trigger event (meaning what event would cause the agreement to come into effect, such as a death or departure)
● valuation process (how the value of the business is determined)
● the rights of each partner
● how shares will be distributed
● payment terms
● tax considerations
Depending on the type of business, other factors may be included in the contract.
There are two main types of buy-sell agreements:
Cross Purchase. This type of agreement allows the remaining partners to purchase the share of the departing partner.
Redemption. In this situation, the company purchases the shares of the departing partner.
A third option, called a Hybrid Buy-Sell, is a mix of the cross purchase and redemption agreements. In this type of agreement, a portion of the shares are available to the partners and the remaining shares are bought by the business.
Many times business partners will choose to purchase life insurance policies that designate other partners as beneficiaries. Both term and permanent life insurance policy pay outs are tax free to the recipients. The payout from the policy can be used to purchase the departed partner’s shares.
Why Do You Need One?
Just like a personal will protects your assets and distributes them to whom you choose, a buy-sell agreement does the same for business partners. It is designed to protect not only the partners but also the business itself. Having an agreement in place makes it more likely that your company will transition smoothly after a partner leaves.
Some reasons to have a buy-sell agreement in place include:
● protect ownership and integrity of the business
● prevent outside investors from gaining control through unapproved sale of shares
● provide clients with continued standard of service and business continuity when a partner leaves
● spell out the method by which the partner’s share and overall value of the business is valued
● limit disputes among remaining partners because everything has been spelled out and agreed upon
● determine a fair value of each partner’s share ahead of time so that remaining partners or next of kin have a clear picture of share worth
● provide peace of mind for all parties knowing that an agreement is in place
When Should You Get One?
The best time to get a buy-sell agreement in place is at the very beginning of your business. Just like having a business plan at the start of your business, the buy-sell agreement establishes a clear plan of what happens when a partner leaves. Outlining how the transition will take place helps to sidestep any potential conflicts, whether they are financial, legal, or personal.
Setting up a buy-sell agreement early on in your business has several advantages, including:
● no substantial business has been done yet
● less chance that other partners will be emotional or biased
● protects the business and partners from the very start
● it is part of the paperwork and other contracts that are put in place to get the business started
If you don’t have a buy-sell agreement already in place, take the necessary steps as soon as possible to put one together. It will help prevent future problems.
Mistakes to Avoid
Setting up your buy-sell agreement takes some thought and discussion with your partners. Because it is a legally binding contract, you will want to ensure that you avoid certain errors. Some mistakes may include:
● Not using professionals. A contract attorney, CPA, and business valuation expert should be consulted to craft the agreement. The document will need to comply with local, state, and federal rules. So you will want to be sure that it is drawn up correctly. Otherwise, it may be unenforceable and of no use.
● Not including real estate. If your business has property, office, warehouse, or other facilities, you will want to include that in the agreement.
● Not adequately identifying trigger events. Does this agreement only apply when a partner dies? Identify all the trigger events you want included. For example, other events like bankruptcy, retirement, incapacitation, exiting the business, divorce, or illness.
● Not revisiting the agreement. Things change in life and in business. It is good to circle back around to the agreement every few years, or after major business changes, to revisit what is in the agreement and see what no longer applies. Some revisions may need to be made to the agreement to reflect the current state of your business.
Final Thoughts
Buy-sell agreements accomplish several things for a business, including protecting the company from within, from inheritors, and from outside influences. When certain events happen in the life of business partners, these agreements are a useful tool to ensure a smooth transition in ownership and continuity.