Buy-Sell Agreements

What Is a Buy-Sell Agreement?

A buy-sell agreement is a legally binding document stipulating what happens to one partner’s ownership if they become incapacitated, pass away, or exit the business for any reason. It serves several functions:

1. It may enable a smooth transition in the control and/or ownership of the business.
2. It may prevent unwanted third parties from acquiring ownership or control of the business without other owners’ consent.
3. It may help avoid disputes by providing a mechanism for determining the value of the business.
4. It may provide a method for funding the buy-out of a departing owner’s interest and establish the terms for the payment of the purchase.
5. It may convert an otherwise non-marketable asset into a source of liquidity for the departing owner or their estate.

Types of Buy-Sell Agreements

There are two common types of buy-sell agreements.

• Cross-Purchase Agreement: This type allows business partners or other shareholders to purchase shares from another partner who becomes incapacitated, dies, or retires (these are referred to as triggering events).

It allows for the seamless continuance of the business if these shares become available unexpectedly. As the simplest form of a buy-sell agreement, the cross-purchase agreement works well for small companies with few owners.

• Entity-Redemption Agreement: With this type, the business itself buys the deceased or withdrawing owner’s share of the business. Each owner must consent to sell their interest under pre-established circumstances. If a partner dies, the company must buy back the shares from their heirs, and the estate must agree to sell it to the company.

Some businesses also utilize a hybrid agreement that grants both the business and the remaining owners the option to buy the departing owner’s shares.  

Valuation Methods

A buy-sell agreement should clearly state the method for valuing business interests to prevent discrepancies and streamline the process.

Fixed Price

The fixed-price method sets a specific dollar amount to be paid for an owner’s interest. While this approach is the most straightforward, it may not necessarily reflect the actual value of the company at the time the triggering event occurs unless it is frequently updated.

Formula Approach

The formula approach assesses earnings, revenues, and other financial statements to determine a book value on a specific date.

Independent Appraisal

An independent appraisal is another option, but it must be agreed upon by all owners when a buy-sell agreement is executed. A reputable appraiser not affiliated with any owners is always recommended in this scenario.

Funding Buy-Sell Agreements

Deciding on a funding method for your company’s buy-sell agreement is another step.

• Life insurance is one of the most popular funding methods used in the event of an owner’s passing. When the buy-sell agreement is created, the business or owners obtain life insurance policies on the owners’ lives. In the case of a cross-purchase agreement, each owner purchases a policy on the life of every other owner. The owners pay the premiums personally and receive the death benefit when another owner passes away, and the proceeds are used to purchase the shares. For an entity redemption agreement, the business obtains a policy on each owner’s life. The business pays the premiums, receives the death benefit proceeds, and redeems the shares from the deceased owner’s estate.
• Disability insurance can be used similarly to purchase the interest of a partner who withdraws due to permanent disability.
• Other funding methods include a sinking fund or installment note.
• Remaining partners can also sell assets to buy the business interest from a partner who is fired, changes jobs, or retires.
  

Buy-Sell Agreements: Additional Considerations

Once you and your attorney have determined the type of buy-sell agreement and how you will fund it, you must consider other factors.

To be legally binding, the contract must be properly drafted and executed. It should also be frequently reviewed and updated as your business evolves to meet your changing needs.

Buy-sell agreements also require coordination with wills, trusts, and other legal documents to try to minimize delays and may possibly pave the way for a smooth transition if an owner leaves or passes away.

When multiple owners are involved, agreeing on the best buy-sell agreement approach can often be challenging. For example, partners may not agree on valuation methods or how to fund the purchase obligation. Each method comes with guidelines, restrictions, and tax implications.

EP Wealth Advisors works directly with shareholders to balance individual and company interests. We explore different funding methods' pros, cons, and alternatives to create a strategy that makes sense for you, your partners, and your bottom line. Work with an experienced attorney to ensure the plan is implemented correctly. EP Wealth Advisors does not have an attorney on staff, however, our business planning and/or estate planning professionals may be able to refer you to an attorney if you do not already have one.

To learn more about our business planning services to protect your business as it grows, find an EP Wealth advisor near you.