Owning your own business can be a challenging endeavor. When you have business partners, it can become even more difficult, especially if something were to happen to one of the partners.
Personal bankruptcy, divorce, and death are some of the changes that can adversely affect a business partnership. A buy-sell agreement can help avert the negative effects of these changes.
Before you start a business with others, it is imperative that you draft a buy-sell agreement.
Regardless of how big or small the business is, a buy-sell agreement can save it from financial collapse in the future.
Below, we’ll look at what a buy-sell agreement entails and why it’s important for your business.
What is a Buy-Sell Agreement?
A buy-sell agreement is also referred to as a buyout agreement. It is a contract that allows for the sale of an owner’s stake of business following various reasons, including:
- Business owner’s retirement
- Irreparable disagreement
The buyer could be a partner in the business, an employee, or third party. If you don’t have a buy-sell agreement, you’re exposing your business to risk.
Here are a few scenarios that could hurt your company:
- Your business may succumb to protracted legal battles as the surviving owners or inheritors contest their entitlements
- The business could end up in the wrong hands such as former owner
- Your heirs may not get fair compensation when you depart
A properly and comprehensively drafted buy-sell agreement can save your business from the above risks.
Four Reasons You Should Set Up a Buy-Sell Agreement for Your Business
We’ve seen that without a buy-sell agreement to protect your business, many negative events can occur.
You may end up with business partners that don’t understand how your business operates or don’t care about its success as much as you do.
Nonetheless, they will still want to have a say in the business, whether you like it or not.
That said, here are some of the benefits of setting up a buy-sell agreement immediately upon starting a business:
Establish a Fair Value Price for Shares
A buy-sell agreement helps in establishing the fair value for an individual’s stake in the business.
This can be helpful if a partner decides to stay in the business after another exists. It plays a great role in averting disagreements about whether a buyout offer is fair.
Namely, a buy-sell agreement sets the figures ahead of time. You’ll avoid situations where a former business partner or their heir demands more money than you think their share is worth.
Create an Exit Strategy for Business Partners
When a partnership business disintegrates, it can be challenging for the business partners to agree on the terms of the break up if those terms aren’t legally binding.
However, a buyout agreement stipulates the terms that business partners need to adhere to in case they exit the company.
This helps to minimize the stresses that come with partnership breakups.
Keep Business Interests With the Remaining Owners
A buy-sell agreement specifies who is entitled to your stake if you exit. Without a well-crafted agreement, the surviving partners or your next of kin may end up fighting for your share.
To avoid such squabbles, which may hurt the business, it is advisable to decide ahead of time who’ll take your share.
This should be done in consultation with your business partners. Otherwise, the decision will have to be made by a lawyer.
Moreover, without a buyout agreement in place, you are leaving you co-owners prone to disruption. Even worse, your business may end up being dissolved if your next of kin decides to sell.
Develop a Business Continuity Strategy
An illness, sudden death, or sale of a part of the business could result in fray among your co-owners.
Having a business continuity plan can help avert some of the negative impacts these challenges can bring.
A continuity plan will spell out the role to be played by each partner and how the various aspects of the business will continue in spite of the challenges.
Types of Buy-Sell Agreements
Buy-sell agreements fall into three major types:
- Cross-purchase agreement
- The redemption agreement
- The hybrid agreement
Let’s take a deeper look at each.
A cross-purchase agreement is a type of buy-sell agreement in which the business partners agree to buy the share of the exiting or deceased partner at a given price.
These types of agreements are often straightforward if there are not more than three co-owners.
However, they can be quite complex when more than three partners are involved. If a business has two owners, for example, each may buy a life insurance policy on his partner’s life.
If the partner dies, the surviving owner uses the proceeds of his life insurance policy to buy the deceased owner’s share.
Such an arrangement can be difficult to implement when the number of co-owners increases.
A redemption agreement, also known as an entity-purchase agreement, is a type of buy-sell agreement in which the business itself purchases the share of the exiting or deceased owner.
The business will normally have a life insurance policy for every owner. At the death of an owner, it will use the insurance proceeds to purchase his share.
Funds for purchasing the departed owner’s share may also be provided by a third party, the selling owners, or a combination of sources of funds.
A hybrid agreement is an integration of a cross-purchase agreement and redemption agreement. In this type of agreement, the surviving partners and the business are required to purchase the share of the exiting or deceased owner.
These types of agreements are sometimes known as “wait-and-see” agreements. Namely, they offer the potential opportunity for surviving owners to acquire shares.
In the event that a partner departs, the business has the discretion to either acquire his stake or to facilitate the acquisition by the remaining stakeholders.
What You Should Consider Before Drafting a Buy-Sell Agreement
You should carefully consider the following elements to craft a solid buy-sell agreement:
- Objectives: You should understand the short and long-term objectives not only of the business but its owners as well. It can be difficult to draft a buy-sell agreement if individual owners have sharply varying objectives.
- Insurance: One of the biggest challenges when the need to exchange shares arises is getting the money to fund a buyout. Therefore, you should consider buying insurance policies, which can come in handy when you need funds for a buyout, especially when an owner unfortunately dies or becomes incapacitated.
- Taxes: It’s imperative that you get acquainted with all tax consequences in case shares are exchanged. Otherwise, you may end up losing a good deal of money, which can be unhealthy for your business.
- Worse-case Scenarios: It is important to take into consideration all worst-case scenarios before putting together a buy-sell agreement. You want to have every possible preemptive clause that guards against such situations.
A buy-sell agreement is a legally binding contract between several owners of a business that stipulates what happens to an ownership interest in the event of various life-changing events.
These events may include divorce, departure, retirement, disability, or death. Without an agreement in place, these events may result in chaos that ruins the business and bankrupt its owners.
A properly drafted and funded buy-sell agreement, on the other hand, assures the remaining stakeholders that the business will carry on successfully.
At the same time, it ensures that the departed, deceased, retiring, or disable owner gets funds that will enable them to meet their various needs and cover their estate settlement costs.
To draft a good buy-sell agreement, you need to take into consideration the business and owners objectives, taxes associated with the exchange of shares, and the worst-case scenarios so you can have clauses to resolve them.