Why a Buy-Sell Agreement Makes Sense for Your Business
What is a buy-sell agreement, and why does your business–no matter how small–need one?
Simply put, a buy-sell agreement answers many large what-ifs for your business.
- What if you–whether you’re a sole proprietor or a partner–were to die suddenly?
- What if you or a co-owner experiences a serious long-term disability?
- What if you and a partner develop disagreements about how to run the company that you can’t resolve?
- What if you, as a sole proprietor, want to sell the company as you transition to retirement?
- What if a partner divorces? Can the spouse receive partial ownership of the company?
A buy-sell agreement (also known as a buy-and-sell agreement, or a buyout agreement) acts as an “umpire” in dealings that follow these events. A buy-sell can be created at any time, though experts say earlier is better.
Four Good Reasons to Have a Buy-Sell Agreement
A buy-sell agreement serves many important functions:
1. It establishes who can become an owner in your business. “A buy-sell restricts the ability of the shareholders to transfer their shares to outsiders, thereby assuring the other shareholders that they will not end up in business with strangers or someone not of their choosing,” says Ross Sharkey, attorney at The Schroeder Group in Waukesha, Wisconsin.
2. It facilitates a continuation of the business. “Another important function, and where the term buy-sell comes from, is that it creates liquidity for the stock of closely held businesses by providing for the purchase and sale of a shareholder’s stock upon certain triggering events,” Sharkey says. “Upon any one of those events, a shareholder must sell, and the corporation or the remaining shareholders must purchase, the shareholder’s shares of stock.”
3. It enables a sole proprietorship to outlast its owner. What if there are no partners to make an agreement with, as in a sole proprietorship? In that case, a buy-sell can be entered into with a qualified buyer(perhaps a relative, a key employee, or even a competitor). Upon the owner’s death or decision to leave the company, the business can be sold promptly, averting estate settlement or cash flow problems for family members.
4. It forces owners to arrive at a valuation for their business. “The process of working through how to value the company often generates insights for the owners and principals about what exactly makes their company valuable, and how they can work to increase that value, even absent a company-changing emergency,” says attorney Donald Sienkiewicz, owner of Estate Preservation & Planning in Milford, New Hampshire.
How to Fund It
Buy-sell agreements are typically funded using life insurance, in one of two main ways. “If it is the corporation that must purchase the shares of the existing shareholder, the buy-sell is referred to as a redemption agreement or entity purchase,” Sharkey explains. “In this case, the corporation purchases life insurance on each of the shareholders, and uses the death benefit proceeds to fund the corporation’s acquisition upon a shareholder’s death.” In what’s known as a cross-purchase agreement, each participating business owner purchases a life insurance policy on the other owners’ lives and can use the proceeds to purchase a deceased owner’s shares.
There are other variations of life-insurance-funded agreements, including a hybrid of the redemption and cross-purchase varieties. Also, there are many ways to fund a buyout in cases where the triggering event is something other than a death. These include using a loan, deferred compensation, cash reserves or installment payouts.
Consider involving your team of advisors (financial, legal and tax). They understand the complexity of buy-sell agreements and will make sure your interests your business are protected. A buy-sell agreement is an important part of making sure that your business is set for the future. The first step to putting together a sound buy-sell agreement is learning what your business is worth.