A buy-sell agreement, or buyout agreement, is a legal contract outlining what happens to a co-owner or partner’s shares if they die or want/need to leave the company. The agreement stipulates what happens to a company’s shares if something unforeseen occurs. It also limits owners’ ability to sell or transfer company shares and improves the control and management of the business.
The agreement will include details about who can or cannot buy the leaving or deceased owner’s shares, how to determine the shares’ worth, and what events will cause the agreement to come into effect.
Most Common Uses of a Buy-Sell Agreement
The buyout agreement stipulates what types of events trigger the contract. It can include specifications about who can buy stocks and the type of life situation triggering a buyout. It might also indicate how the purchase will be financed. Here are the most common triggers for activating a buy-sell agreement:
- Death: The most common trigger is the death of a business owner. Life insurance policies are often used to fund the purchase of the deceased owner’s share of the business.
- Disability: Long-term disability can prevent an owner from continuing to contribute to the business, prompting using disability insurance to buy out the disabled owner’s share.
- Retirement: Planned retirement is a trigger to ensure the smooth transition of ownership and management as one partner exits the business.
- Divorce: To prevent an owner’s ex-spouse from obtaining a stake in the business, buy-sell agreements often include provisions that address what happens to the shares in the event of a divorce.
- Bankruptcy: If an owner declares personal bankruptcy, a buy-sell agreement can prevent creditors from claiming the business shares.
- Voluntary Sale: This trigger covers a situation where an owner wishes to sell their interest voluntarily. The agreement often includes a right of first refusal for the other partners or the business, ensuring the company can control who owns shares.
- Involuntary Transfer: Similar to divorce and bankruptcy, this provision is triggered to prevent unwanted third parties from becoming owners due to other involuntary transfers of shares, such as through creditors, legal judgments, or inheritances.
Many businesses use life insurance policies to plan and execute the buy-sell agreement. For multiple co-owners, the company’s market value would be estimated. The other owners or the company would then ensure each partner for their portion of the company’s total worth.
In the case of an owner’s death or incapacity, the remaining business partners would use the proceeds from the life insurance policy to purchase the shareholder’s shares, with the valuation price going to the deceased owner’s family.
This mode of accounting for the total cost of the transferred shares is also useful when a sole proprietor wants to pass the business on to an employee or an heir.
Common Mistakes Made with Buy-Sell Agreements
If done right, buy-sell agreements set out the terms and conditions for a business’s shares if something unexpected occurs and restrict how owners can transfer or sell company shares.
Any mistakes in the creation of a buy-sell agreement can lead to legal complications later on, so you’ll want to ensure you avoid these common mishaps:
- Not communicating with all parties involved
- Failing to detail trigger events
- Continue using an outdated agreement – keep your agreement aligned with the owner’s current or future goals!
- Forgetting to account for provisions once an event triggers
- Vague or outdated valuation methodology
- Buy-sell is unfunded, or funding is structured incorrectly
- Missing out on a real estate
What Should Be Included in a Buy-Sell Agreement?
Each business is unique in structure. A company with multiple co-founders would have a more complicated buyout agreement. In contrast, a sole proprietorship is often more straightforward to draft and execute.
This list will give you a general overview of clauses and scenarios that should be considered in most buy-sell agreements.
- Triggering Events. Defining which events will trigger a buyout is crucial when drafting this agreement.
- Death of an Owner / Partner. Without a contract, an owner’s share in the company would pass to their heirs. This might not be ideal for the business or remaining business partners. The contract should include a provision stipulating what will be done with the owner’s share of the industry at their death. This might involve transferring the shares to family members for a buyout price. Or it might just allow the company to repurchase the deceased owner’s shares.
- Divorce of an Owner. Divorce can pose a particular risk for companies because the dissolution of a marriage is often not amicable. Without a buy-sell agreement, the court could grant an ex-spouse ownership of shares, compromising business interests and company operations. This segment of the contract would stipulate that company shares could be purchased back by the company rather than being transferred to the ex-spouse permanently.
- Disability or Long-Term Illness. In many companies, the business owners represent a good portion of the company’s worth. Their work has value and will need to be continued in their absence. Suppose an owner suffers a long-term illness or has some health event that permanently impairs their ability to meet the requirements of his position in the company. In that case, you might include a clause to trigger the commencement of the buyout agreement. In this case, the contract will stipulate a clear timeline – how long must the party be unable to work before the buyout is enacted? There may also be clauses for the owner’s interest that allow them to buy back their shares if they can return later.
- Personal Bankruptcy. The buyout agreement should also include a clause allowing the company to purchase back shares if an owner experiences severe financial issues. In bankruptcy cases, creditors might go after the owner’s shares in a company.
- Internal Conflict Between Partners. Partnerships can suffer from personal and professional conflicts no matter how successful the venture is. Sometimes, these internal struggles are not fixable. With this agreement in place, there’s a set way to sever the partnership, which is fair to all parties.
- Retirement Specifications. It should be assumed that all partners will eventually want to retire. This clause would specify the age of retirement. You might also include whether shares will be retained by the owner or sold back to the company. You may also want options for founding owners to stay on in a part-time or advisory capacity.
- Early Buyout. There should be a clause for owners to leave the company if they pursue other opportunities amicably. This clause would set parameters for the remaining owners to buy back those shares.
- Payment Structure. The payment structure for a buyout agreement would specifically designate who is entitled to purchase shares in the buyout and how those payments would be made. This clause would include specific information, such as a percentage of shares each remaining partner can purchase. This structure has different possibilities depending on the number of partners and the corporation’s size.
- Fair Price Valuation. Your business worth can’t be mapped out in advance because the value will fluctuate over time. For a buyout agreement, determining the value of the business at the time it’s triggered has to be agreed upon. Some companies use a formula to determine the company’s current fair market value. This saves the fees associated with hiring a professional appraiser. The other option is to have an experienced business valuation completed. Depending on the type of business, you might also need to stipulate what is being sold in the buy-sell agreement, separating personal from business property where applicable.
- Financing. A section of the agreement should discuss acceptable payment methods. Possible options include life insurance policies, loans, installment payments, cash or certified checks, and stock options, to name a few. Other arrangements, such as deferred payment, might be stipulated for sale to key employees.
- Right of First Refusal. This section verifies that the remaining shareholders are entitled to repurchase the shares according to the pricing structure stipulated in the buy-sell agreement. No shareholder can sell or transfer shares to an outside entity.
A buy-sell agreement offers a concrete way to protect your business’s future and ensure it continues past your involvement.
