For many businesses, it is essential to have a buy-sell agreement in place from the outset of operations. In this article, we explain what a buy-sell agreement is, why you might need one, and best practices for valuing your business and creating a buy-sell agreement.
What is a buy-sell agreement?
A buy-sell agreement is an important part of properly establishing your business entity and can limit liability in your business structure. The buy-sell agreement prevents an owner from selling their interests to an outsider without the consent of the other owners. It also provides an orderly and equitable method of determining the value of each owner's interest in the business.
Buy-sell agreements are typically used by businesses structured as partnerships and closed corporations. Essentially, they ensure a smooth transition of ownership should a partner retire, die, or exit the business.
State statutes governing the statutory close corporation may also mandate owners to enter into a buy-sell agreement. A buy-sell agreement may even be used by a limited liability company (LLC), conventional corporation, or sole proprietorship (where it is used to designate an employee as a purchaser of the business or business successor).
It’s important that you understand your state’s statute for buy-sell agreements. Ownership certificates (such as the share certificate of a corporation) must include a legend with the restriction on transfer created by the buy-sell agreement. In many cases, state statutes stipulate precise language be used in ownership certificates.
What are the reasons for having a buy-sell agreement?
If you want to transfer your business interest, a buy-sell agreement can be the most efficient way to do so. A buy-sell agreement ensures:
- Business continuity: In the event of death, retirement, or incapacity, you can ensure the seamless continuation of your business.
- Compensation: Any survivor or designated successor will be properly compensated for the deceased owner’s interest.
- Assurance: Remaining owners can be sure that the deceased’s business share is not passed onto someone deemed unsuitable.
- Asset protection: If a triggering event occurs, the agreement creates a source of funding and liquidity and mitigates the need to sell assets.
Types of buy-sell agreements
A buy-sell agreement usually takes one of three forms:
- Cross-purchase agreement. In this form, a withdrawing owner agrees to sell their interest to the remaining owners. This is the simplest form of the buy-sell agreement and is suited to small businesses with only a few owners. As the number of owners increases, this form can become unwieldy and an entity-purchase agreement may be more suitable.
- Entity-purchase agreement. In this form of the buy-sell agreement, the withdrawing owner agrees to sell their interest to the entity, which then retires the ownership interest.
- Hybrid agreement. This form is a combination of the first two. Typically, the withdrawing owner must first offer their ownership interest to the entity. If the entity declines or is unable to make the purchase, then the shares must be offered to the other owners.
Buy-sell agreement for an LLC
If you operate an LLC, then a buy-sell agreement may be a provision within your operating agreement. However, it could also be a separate agreement if preferred.
For an example of buy-sell provisions for a member's resignation, death, or other transfer of an interest, refer to this sample operating agreement for a Delaware LLC.
Note: The sample operating agreement is for illustration purposes only. An operating agreement should be professionally drafted and tailored to the needs of the owners and the business' operations.
What should be included in a buy-sell agreement?
To avoid disagreements, a buy-sell agreement describes how an interest will be sold but also for how much.
Elements of a buy-sell agreement include:
- Any stakeholders, including partners or owners, and their current stake in the business’ equity.
- Events that would trigger a buyout, such as death, disability, divorce, retirement, or bankruptcy.
- A recent business valuation.
- The structure by which partners would buy or sell their interest in the business.
- A recent business valuation.
- Buyout funding sources (ex. insurance policies).
- The tax implications of the purchase or sale of any partner’s interest in the business.
Common valuation methods
The buy-sell agreement should clearly specify the method for valuing your business interests. The problem is most people have a hard time agreeing on that price. What is valuable to one person may have little value to another. In addition, your business is comprised of any number of variables, each possessing its own values. As with any major purchase, a deal must be negotiated to reach the final price.
To simplify the buy-sell process and ensure fairness for all owners, your buy-sell agreement should specify how your owners' interests are to be valued. Common valuation methods include
- Fixed price: This appears a simple method, but often the initial fixed price is not updated. For example, it may not reflect the value of the business when the triggering event occurs.
- Independent appraisal: This is agreed on by the owners when the buy-out agreement is executed. An appraiser can help, but they should be independent of the business, the owners, and affiliated with a reputable appraisal company. Although a best practice, this method can be costly and potentially delay any settlement.
- Formula approach: This involves valuing financial statements, such as earnings or revenues, and determining a book value at a specific date. However, to remain realistic, the valuation should be revisited and adjusted as the business evolves.
A buy-sell agreement can be as flexible as you and any other owners wish it to be. Different methods of valuation can be applied over the life cycle of the business. For instance, the agreement can initially provide use the formula approach. During the first year, a new business is unlikely to generate significant goodwill or appreciation of its assets and relationships among the owners could be especially unstable.
Thus, the agreement can specify, during a one-year period after the buy-sell agreement is signed, that fair market value is presumed to be equal to book value. This eliminates the expense of an appraisal, which would likely yield a result that approximated book value.
The buy-sell agreement also can apply different methods to fix the purchase price based upon the circumstances triggering the sale. For example, if the owner files bankruptcy action, the agreement might fix a lower amount (e.g., book value) as the price but a higher value (e.g., book value plus a percentage, or appraised fair market value) in other circumstances.
This strategy is open to challenge, so advanced strategies, such as this one, should only be employed with the advice of an attorney.
Funding the buy-sell agreement
To be successful, our business’ owners should arrange for funding to ensure they can “buy-out” the person who has exited the business.
Popular funding methods include:
- Life or disability insurance
- Installment note
- Sinking fund
- Selling assets
Deciding on a funding method typically depends on your business structure, ownership percentage, tax bracket, and the age of the owners.
One of the most popular methods to fund a buy-out is life insurance. Obviously, life insurance can only be used to fund a purchase in the event of an owner's death.
Disability insurance is another option. For example, the operating agreement might allow withdrawal by an owner who suffers a permanent disability (e.g. a disability that prevents the owner from working in the business for six consecutive months). Disability insurance might be used, in the same way life insurance is used, to facilitate the purchase of the interest. Note: The operating agreement may provide that an owner may not withdraw, except upon unanimous consent or subject to other enumerated conditions.
Furthermore, your buy-sell agreement might state that in specific situations, like when someone chooses to leave, the value of their interest is assessed as a lower amount. Additionally, the agreement could specify that the interest is bought gradually, over a set period, such as five or ten years. These choices can make it easier to buy the interest.
Remember to keep your buy-sell agreement updated
Because business affairs constantly change, your buy-sell agreement should be periodically reviewed to ensure it reflects your current circumstances and any future plans.
Most importantly, revisit your agreement’s valuation provision to ensure that it reflects the current value of your business.