What every business owner should know about buy-sell agreements

Buy-sell agreements are essential for business succession planning, providing continuity for both planned exits and unexpected changes a business owner’s circumstances.

Here's what they are, why they matter and what to consider in creating one.

Buy-sell agreement fundamentals

The “buy-sell” earned its name because this legally binding contract sets out the terms under which a business owner’s stake will be bought and sold. The contract pre-determines what happens to a business owner’s stake whenever a previously agreed-upon “triggering event” occurs. These triggering events can address a wide range of circumstances, from a timely planned retirement to divorce or untimely death – any scenario that the business owner(s) believes could jeopardize the business’s well-being. It is important that business owners customize the triggering events to their specific situation.

Under the agreement, when a triggering events happens, the remaining owners – or, in the case of a sole proprietorship, family members or key employees – buy the owner’s share according to the contract’s existing terms.

Advantages of buy-sell agreements

A buy-sell agreement benefits everyone involved. If an owner dies, the surviving family is guaranteed a buyer and receives timely liquidity to replace lost income or settle estate taxes. At the same time, the surviving business owners purchase the shares and continue operations uninterrupted, without having the deceased owner’s – perhaps unwanted - family as new partners. In this way, the remaining owners avoid the risk that the ownership stake will be sold to an unapproved outsider.

Likewise, in the event of a divorce, one spouse continues to be part of the company while the other receives fair compensation for their ownership stake.

By defining up front what happens after a triggering event – whether as simple as deciding to leave the business or as unsettling as bankruptcy, incapacitation or disability – buy-sell agreements offer clarity and predictability during a period of change.

Key provisions and considerations

In structuring a buy-sell agreement, you should carefully consider the provisions relating to transfer restrictions, triggering events, buy-sell structure, valuation, purchase term and funding.

Transfer restrictions. Often, an agreement will first eliminate who cannot be owner, by narrowing who can be an owner. It may contain provisions that prevent transferring shares to people outside of the buy-sell agreement, but may make exceptions for family members, trusts, or related companies. This provision can be enforced by voiding the transfers or offering a “Right of First Refusal,” giving the current owners an option to purchase the transferred shares.

Triggering events. The agreement should explicitly define which life and business events set a buyout in motion. The business owners can add any potential triggering event that they believe could apply to them. In addition to death, disability, divorce, or bankruptcy (as previously mentioned), the agreement can include other triggering events such as operation of law, withdrawal, deadlock, loss of professional license, or drag-along / tag-along.

Structure. There are several types of buy-sell structures:

• A one-way agreement is an effective approach for sole proprietors and involves a key employee or family member buying either part or all the business from the estate.
• A cross-purchase agreement is ideal for companies with two owners. This structure involves the remaining owner buying the departing owner's shares.
• A cross-endorsement agreement works for businesses taxed as a partnership or companies that have a related business that is taxed as a partnership (for example, a real estate partnership that rents the building to the primary company). Each business owner is the owner of their own policy and endorses life insurance death benefit to the other business owners.
• An entity purchase agreement works well for companies with multiple owners. The company buys back the departing owner’s shares instead of each remaining owner buying a portion.
• A business continuation LLC agreement creates a new business in order to obtain the benefits – and avoid the pitfalls – of both the cross-purchase agreement and the entity purchase agreements.

Businesses may also combine different aspects of these approaches. For example, a family business may give a retiring owner's children first right of refusal, with the company as a mandatory backstop buyer if shares remain unpurchased.

Valuation. This is often the most controversial provision, with each potential approach presenting drawbacks. Options for valuing the business include:

• Certification Method: a fixed price that provides owners autonomy over the value of their business, but is only reliable if updated regularly;
• Formula Method: the use of one of several industry-accepted formulas tied to a combination of book value, profitability and goodwill; this method generates an objective, but rough, proxy for worth; or
• Appraisal Method: an independent appraisal at the time of the trigger using comparable business sales, which is most accurate, but slower and far more expensive.

Many businesses take a hybrid approach. They use a formula as the default method but allow either side to request a full appraisal if the result no longer reflects fair value. This approach balances cost-efficiency with a safety valve against an outdated price.

Purchase Terms. Mutually agreeable purchase terms can be difficult to reach under the best of circumstances, let alone following a death or other triggering event. These important details can be pre-determined to require the choice of – or combination of - of  lump sum, down payment, installment payments, or a balloon payment, along with the interest rate and potential penalties or defaults. 

Funding. When a triggering event occurs, those buying the departing owner’s share need significant funds to do so. Buy-sell agreements spell out where that money comes from. Life insurance on each owner is the standard funding tool for death-related triggers, and disability insurance funds the purchase of an owner who becomes incapacitated.

For other departures, such as those involving termination, bankruptcy or divorce, owners must rely on cash reserves, installment notes, personal funds or loans to purchase the shares.

Make it a priority

Ideally, you would create a buy-sell agreement when you form your business. But, better late than never. A well-structured agreement can give you confidence, protect your family and help your business effectively navigate planned or unexpected departures.

Insurance products are offered through Raymond James Insurance Group. Raymond James & Associates, Inc. and Raymond James Financial Services, Inc. are affiliated with Raymond James Insurance Group.

Life insurance policies have exclusions and/or limitations. The cost and availability of life insurance depend on factors such as age, health and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company.