You’ve spent years building your business. Now it has a loyal customer following and a strong reputation in the market. Your company also has growing revenues and produces a steady stream of profits.
But what if you or one of the other co-founders has to exit the business suddenly?
The disability or death of a partner could result in a share of the company falling into the wrong pair of hands. You wouldn’t want that to happen. But how can you prevent one partner’s share from being passed on to someone unsuitable?
That’s where a buy-sell agreement comes in.
In this post, we’ll explain what a buy-sell agreement is and why it’s important. We’ll also tell you what it should include and how to ensure that it safeguards the interests of each of the owners.
What is a buy sell agreement?
The term buy sell agreement can be a little misleading. It conjures up an image of a company being sold. However, the words “buy-sell” refer to something else altogether.
This type of agreement protects the owners of a company when one of them has to leave because of disability, death, or some other reason. A buy sell agreement is a legal contract that specifies how to handle the share of the person who is leaving.
It stipulates how the exiting partner’s share will be sold. In most instances, the existing partners purchase this share.
The buy-sell agreement also provides the valuation method for the company.
This agreement is also known by several other names:
- Buy and sell agreement
- Buyout agreement
- Business will
- Business prenup
Why is a buy sell agreement important?
There are several reasons for every company to put a buy-sell agreement in place:
It can help retain ownership of the company
The agreement sets out how the share of the partner who is leaving will be sold. It could be useful for sole proprietorships. The owner may want a specific family member or a trusted employee to take over the firm.
It can provide an exit strategy
Say, one of the partners of a firm wants to sell his stake in the company. The buy sell agreement could specify who would be eligible to purchase the shares.
It can lay down the procedure to arrive at a value for the business
It’s a good idea to decide on this issue beforehand. There are several methods for valuing a company. It could be done based on the firm’s tangible assets or as a multiple of earnings.
It can save the situation if one of the partners has a messy divorce
About 40% to 50% of marriages in the country end in a divorce. If one of the partners of a company is getting divorced, the ownership may pass on to his or her spouse. A buy-sell agreement could prevent this from happening.
What should a buy sell agreement include?
The agreement should address issues that are specific to your business. However, make sure to include:
When will the buy-sell agreement kick in?
The agreement needs to incorporate this critical factor. If you don’t define the conditions under which it will come into force, the buy sell agreement will not serve its purpose.
Typically, the agreement will come into effect in the following conditions:
👉🏼 One of the partners dies
👉🏼 A partner becomes disabled or decides to retire
👉🏼 There’s a disagreement between the partners
👉🏼 The bankruptcy of one of the partners.
How will the business be valued?
The buy-sell agreement must describe the method of valuation. This will reduce the possibility of a dispute with the transferred share.
How will the payment be made?
Each of the partners of a business may decide to buy a life insurance policy. If one of them dies, the payment from the insurance company could be used to pay for that partner’s share of the business.
Similarly, disability insurance could be used to fund the payout in the event one of the partners is unable to continue working due to health issues.
Types of buy sell agreements
Remember that there are three main types of buy-sell agreements:
This stipulates that the remaining partners buy out the partner who dies or leaves the company.
If one partner dies, a life insurance policy can fund the payment for his share. To prepare for this eventuality, each partner buys a life insurance policy that names the other partners as beneficiaries.
This doesn’t involve the remaining partners buying the exiting partner’s share. Instead, the company buys out the partner who is leaving.
Also known as a combination agreement, this variation is a mix of a cross-purchase agreement and a stock redemption agreement. A hybrid agreement could involve the exiting partner offering his shares to the company. If this offer is not accepted, the remaining partners may buy the shares.
Tips for writing the best buy sell agreement
Ready to write your buy-sell agreement? Don’t forget to do these things:
- The valuation clause should be unambiguous: The value at which shares are to be transferred is a vital issue. It can lead to a dispute. Make sure that your valuation clause is clear-cut and comprehensive.
- Consider the tax implications of a transfer: It’s useful to think about this in advance. You don’t want to pay taxes that are possible to avoid. Consult a tax expert when you make your buy sell agreement.
- Revisit the agreement periodically: Every time there is a change in the ownership structure, you need to review your buy-sell agreement.
It’s a good idea to get professional help when making your buy sell agreement. Among the people you should consult are an accountant, a lawyer, a tax expert, and a valuation professional.
Here’s a buy-sell agreement planning checklist that you may find useful.
The bottom line
A buy sell agreement is the best way to retain control of your business if one partner decides to leave. It provides a fair method for transferring ownership and should be a part of the business continuity plan for every company.
If the name buy-sell agreement deceived you and you were looking for information about buying or selling a business, we’ve got you covered. We invite you to keep reading:
At Camino Financial, we strive to live up to our motto, “No business left behind.” One of our initiatives is to provide entrepreneurs with the information and resources they need to manage their companies effectively and profitably.