Importance of Buy-Sell Agreements

August 19, 2021by Brandon Banks

Buy-sell agreements, also known as a “business prenuptial” agreement, are often overlooked in the excitement of starting a new business and the certainty that the founders or partners will work happily together for their lifetimes.

Often best friends, even family members, owners fail to consider the possibility that adversity can strike at any time. In cases where buy-sell agreements exist, they are often stored away with previous corporate or partnership minutes. They are out-of-sight, out-of-mind until calamity hits or an intractable dispute rises between partners or shareholders.

The lack of or outdated buy-sell agreements often ends with expensive lawsuits, personal estrangements, and damage to the business in question. Foresight and periodic review of the principals, the company, and the agreement can limit the trauma and costs of losing a partner.

Understanding

The Purpose Of
Buy-Sell Agreements

Buy-Sell agreements are an important part of the legal foundation of any business. They outline how a stakeholders interest in a business is to be reassigned due to death, incapacity of or other trigger events occur.

A buy-sell agreement is a contractual arrangement between shareholders or partners or the shared business detailing conditions by which ownership interests transfer between the parties in certain events, including death, disability, divorce, financial incapacity, exit from the company, or a management stalemate. A buy-sell agreement recognizes the possibility of future adverse events and prescribes a process agreeable to the respective parties for the continuation or dissolution of the business enterprise.

Negotiation between the various parties, usually with the assistance of an attorney experienced in business and contract law (Federal and State), establishes the agreement’s terms. A buy-sell agreement resolves issues like how, when, to whom, and for what price ownership interests can be sold, thereby protecting the exiting shareholder (liquidity) and the remaining shareholders (control).

The terms of a buy-sell agreement can be simple or exceedingly complex, specifying such details as the valuation method of the asset to be sold, the payment terms (lump sum or serial), or time frames.

Example: BJ Auto Repair Shop

Bill and Joe, brothers-in-law, co-own an automobile repair business. Both are active in the business and split profits 50-50. The company is a significant asset in each man’s net worth and provides each an after-tax income of $150,000. Bill unexpectedly dies, and the business suffers an immediate drop in revenues due to Joe’s inability to pick up the work Bill previously handled. Nevertheless, Bill’s widowed wife relies on the income from the business.

Fortunately, Bill and Joe agreed early in their partnership that the business would purchase a deceased owner’s interest in the company for four times the 5-year-average of a partner’s income. A joint insurance policy purchased by the company provided funds to complete the transaction. Bill’s widow received $700,000 for Bill’s share of the business, and Joe became the single shareholder. He hires a mechanic for less than one-half of what Bill earned as an owner. Without a buy-sell agreement, liquidation of the business might be necessary to provide an income to Bill’s widow.

Who Are The

Parties to a
Buy-Sell Agreement

All owners of a privately held company with limited liquidity benefit from a buy-sell agreement:
  • Selling shareholders. Without a buy-sell agreement, especially for a non-controlling interest, selling is likely to be difficult and require a significant discount from market value. A buy-sell establishes a price and can ensure a transaction.
  • Buying shareholders. A buy-sell agreement ensures that the business continues without the inconvenience of dealing with heirs or custodians, so that new partners are of the buying shareholder’s choice.

Some buy-sell agreements are in the form of a “cross-purchase agreement” between partners or shareholders. When a partner leaves the business for any reason, the remaining individual partners agree to buy their shares.

A second popular type is a “redemption agreement,” whereby the company purchases the leaving shareholder’s interest on behalf of all shareholders. In most cases, a life insurance policy funds the purchase of the exiting partner’s share.

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What Are The

Reasons to Have
A Buy-Sell Agreement

“Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.”
                                                        —- Peter Drucker

Estate Planning

For many people, their most significant asset is the business they own. Unlike stocks and bonds, privately held companies and partnerships are not easily nor quickly liquidated. In many cases, heirs are neither qualified nor interested in replacing the deceased in the business. A properly negotiated and executed buy-sell agreement ensures that a jointly owned business asset is liquidated at a fair price with payment terms according to the deceased owner’s wishes.

Business Continuity

The death of a co-owner or partner is typically a traumatic event, especially for the surviving shareholders left to pick up the pieces. Trying to navigate the emotional and financial issues without a pre-agreed settlement is liable to damage relationships, reputations, and asset values, possibly ending in the liquidation of the business. Few surviving partners are eager to share control of the business they have worked to build with the spouse or children of the deceased. Failure to consider the succession of ownership exposes the company, the living partner(s), and the heirs to extended legal proceedings and loss of value. In other words, a buy-sell agreement allows the surviving shareholder(s) to select future partners of their choice.

Competitive and Proprietary Secrets

Few partnerships are as successful as that of ice cream magnates Burton Baskin and Irvine Robbins. More than one-half of partnerships or closely held businesses break up within ten years.[i] Effective buy-sell agreements preclude a disgruntled shareholder or a principal’s heirs from selling their interest to a competitor or other hostile parties.

What Makes

An Effective
Buy-Sell Agreement

Like all contractual agreements, the terms of a buy-sell can vary significantly from one agreement to another. Thus, each agreement can be customized to fit the needs of the parties.

Buy-sell agreements are reciprocal. Since no one knows if they or their partner will be the first to die, suffer from a disability, or retire, the mutual reciprocity makes negotiating and agreeing on issues more straightforward than you might think. At the startup phase, owners likely share the same goals for the company and are optimistic about its chances for success. Nevertheless, having an experienced counsel’s advice is always wise.

An effective agreement covers the following conditions and issues:

  • Parties to the Agreement– A buy-sell agreement in the form of a cross-purchaseshould include all partners and shareholders. An agreement in the form of a redemption necessarily includes the company as a party. In the latter case, the contract would be between the business and each shareholder or partner.
  • Triggering Events– Circumstances applicable to a buy-sell typically include death, disability, divorce, retirement, bankruptcy, management impasse, and termination (voluntary or involuntary).
  • Valuation of Asset– The valuation methods of the transferred asset include (1) an independent appraisal of the business, (2) use of a predetermined formula such as a multiple of asset value, earnings, net worth, or another metric, or (3) an agreed fixed amount. A provision to regularly review the valuation method is essential.
  • Payment terms– The agreement may require a single lump-sum payment or a series of payments over a specific period, with or without interest. The payment type option may reside with the beneficiary of the payments to minimize their tax obligations or the buyer to minimize cash flow obligations.
  • Required/Optional– The obligations of the party to acquire the selling party’s interest may be mandatory or optional and can vary according to the circumstances triggering the buy-sell provisions. For example, a seller may not be obligated to sell shares only to the other parties of the agreement but to offer them a “first right of refusal” on the same terms provided to an independent third party. Similarly, the purchaser might have an “option” to purchase, but not the obligation. If the purchaser fails to exercise their option, the selling party can solicit other buyers under the same terms offered to the partner.
    A “put or take” clause – usually imposed when one of the parties will not work with the other – permits either party to offer to sell their shares or buy the shares of the other party under specific terms. The party receiving the offer must respond by either selling their shares at the offering price or buying the offeror’s interest for the same valuation. In either case, one of the parties loses their ownership and typically leaves the business.
  • Funding– A presumption of a buy-sell agreement is the capacity of the buying party to complete the transaction. In the cases of death or disability, the obligation is typically secured by insurance. In a cross-purchase agreement, each partner owns insurance on the other’s party’s life or health, while the business owns the insurance in a redemption contract. Parties to a buy-sell agreement should consider their potential funding obligations when determining payment terms.

A Few Final Thoughts

The cost of a buy-sell is minimal compared to its benefits. A buy-sell agreement can minimize bickering by family members, co-owners, and spouses, protect the business operation, and avoid liquidity problems associated with the departure of a partner.

A buy-sell agreement needs to be as clear and as unambiguous as possible, especially the use of language and standard terms. For example, “fair value” and “fair market value” are not legal equivalents.

The existence of a buy-sell agreement is not a guarantee that a partner’s departure will be smooth and orderly. The courtrooms are full of former partners and heirs contesting agreements they feel to be unfair. Even so, the existence of a buy-sell agreement is better than no agreement.

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