Having a buy sell agreement in place is essential for companies that want to mitigate certain risks that could ultimately destroy their business. What is a buy sell agreement? It is a legal contract between multiple owners of a business that describes how ownership will be situated in the event that a co-owner passes away or chooses to exit the business. Despite the name, a buy sell agreement does not refer to the buying or selling of a company. Instead, the agreement outlines when an owner can sell their interest, who can purchase the interest, and at what price it can be sold. This formalized business continuation plan should exist in every business that has multiple co-owners.
How a Buy Sell Agreement Works
A buy sell agreement allows an owner of a business’ interest to enter into an agreement that will control a future sale of that interest if a disability, death, or retirement should occur. Under this type of arrangement, the specified buyer is under legal obligation to buy the interest. Based on the unique contract, the estate must also agree to sell if the terms are met. Buy sell agreements are used by a wide range of businesses, such as partnerships, sole proprietorships, and closed corporations.
Under a buy sell agreement, there are two primary types of agreements:
- Cross-Purchase Agreement – With this type of buy sell agreement, the remaining owner(s) of the business agree to purchase the share of the company that is for sale.
- Redemption Agreement – Under a redemption agreement, the business entity agrees to purchase the share of the business.
In some instances, owners of a business may choose to combine the two types of agreements by making some portions available for partners to buy, while offering the remainder to the partnership.
Why Create Buy Sell Agreements
There are a number of reasons why businesses rely on buy sell agreements. Even if you trust your co-owner to make good on his word, having a deal in writing can provide peace of mind for all parties involved. An agreement can also establish the fair value of each owner’s share in the business, which can be useful when a scenario occurs that results in the departure of one partner. A buy sell agreement acts as an exit plan so that neither partner is forced to make rash decisions when an unexpected event occurs.
It can be difficult for partners to agree on how a business should be split in the heat of the moment. With a buy sell agreement in place long before its needed, business interests can stay with the remaining owner if the other should pass away, retire, or decide to leave the company for whatever reason. Without an agreement in place, an unplanned successor may step in to fill the role, such as a partners’ next of kin. This is not the type of decision you want to make at the last moment. Having a plan in place is vital to prevent disruptions in your business.
How to Set Up a Buy Sell Agreement
A buy sell agreement, also known as a “buyout” agreement, should include some paramount information to ensure that there is no confusion later on about the ownership details of the business. Every buy sell agreement differs based on the unique situation that the business is in and the terms desired by the owners. However, there are some specific things that most buy sell agreements should contain.
First, you will want to meet with your partner to determine what will happen to the business in various scenarios. For example, in the event of the death of one partner, who would his business interests go to? That partner may indicate that his part of the business goes to his spouse or child. A buy sell agreement may also give the surviving owner the option to purchase the deceased partner’s share from his heirs if the co-owner is able to meet the buyout price indicated in the agreement.
If one partner becomes disabled and is unable to work, state in the agreement how the business will operate. If one partner becomes disabled, the buy sell agreement may state that the other owner has the right to buy out the disabled partner. However, it is important to clearly define what is considered a disability. For some, a disability may constitute an illness or injury that consists for more than one year, while others may consider it an illness or injury that lasts at least six months.
Divorce is another common scenario that can affect how a business is divided. If one owner gets divorce, a portion of the business may legally go to the ex-spouse. With a share of the business, the ex-spouse could potentially exert some control over the company which could be problematic for the original owners. A buy sell agreement can give the original owners the right to buy out the business from the ex-spouse.
There are also other situations that could arise that you may want to include in your buy sell agreement. State what will happen in the event of a bankruptcy, retirement, or a conflict among co-owners. Also outline what will happen if one owner wants to leave the business voluntarily. With a buy sell agreement, business owners can set limits on when an owner is able to voluntarily “cash out” of a business. This is crucial to avoid business disruptions.
Learn More About Buy Sell Agreements
Buy sell agreements are an invaluable tool for pre-determining the rights of remaining owners and departing owners in the event that one party leaves the business. Setting up a buy sell agreement can also be useful in establishing a method for determining the value of a business. As setting up a buy sell agreement on your own can be complicated, it is wise to seek the advice and guidance of an experienced financial advisor. For more information about buy sell agreements, contact the benefits consultants at BBG Broker.