Owners of closely held businesses may not think about what will happen when a co-owner wants to sell his or her interests in the business, unexpectedly passes away, files for bankruptcy, or goes through a divorce. If you don’t know what would happen to your business and its ownership in one of these situations, you should consider a buy-sell agreement or amending your existing business documents. Afterall, preparation and planning are essential to sustaining any business. These situations do not need to disrupt your business operations. Buy-sell agreements allow owners to avoid costly litigation while preserving their involvement in the company and asserting decision-making authority with regard to who gets to be a fellow co-owner.
Buy-sell agreements in general:
A buy–sell agreement, also known as a buyout agreement, is a legally binding contract between co-owners of a business that dictates what happens if a co-owner dies, is forced to leave the business, or chooses to sell or retire. Buy-sell agreements are often standalone agreements but can also be included in the company’s other agreement(s). Most companies with more than one owner will already have a “shareholders’ agreement” (corporations), “partnership agreement” (partnerships), or “operating agreement” (limited liability companies). None of these agreements are required to form or operate any particular type of business entity, although it is highly recommended to have one.
What these agreements all have in common is that they are formal agreements among the owners designed to govern how the company operates, the ownership interests of each co-owner, the roles of its owners, and any other rule imaginable. Often left out though is a detailed business succession plan to dictate what happens in certain situations, like the death, retirement, termination, withdrawal, or insolvency of the owners.
It is sometimes a good idea to have the company itself as a party to the buy-sell agreement and any spouses of the owners. Afterall, the company and any spouses may have their rights and obligations affected by the terms of the agreement. For example, a buy-sell agreement may require the company to purchase the ownership interest of an owner upon his or her death. This will avoid a situation where the other owners end up sharing their company with the deceased owner’s spouse or other heirs.
A buy-sell agreement can be extremely detailed in contemplating the scenarios, but at a minimum should contain some basic clauses:
- The triggering events that precede a forced buyout, i.e., death, disability, retirement, or termination;
- The price that will be paid for a co-owner’s interest;
- How the buyout will be funded, i.e., insurance, company funds, or personal funds; and
- Who can buy the departing co-owner’s interest of the business, i.e, other co-owners versus outsiders.
Buy-sell agreements can be tailored to address just about any situation. Commonly, they are used to plan for:
- The death or disability of an owner;
- The voluntary transfer of ownership interests;
- Exits or withdrawals of owners;
- The retirement of any owner;
- The insolvency or bankruptcy of any owner;
- The termination of the employment of someone who is also an owner;
- The divorce of a co-owner, particularly in community property states;
- Any deadlock or prolonged dispute among the owners.
These situations are known as “triggering events.” The scenarios that constitute triggering events in a buy-sell agreement need to be thoughtfully considered and defined. It is just as important to carefully detail the procedure, process, and timelines of the buyout that follows a triggering event.
Valuation and funding:
The terms of a buy-sell agreement govern how an owner’s interest will be valued upon the occurrence of a triggering event. Owners should work carefully with their attorney to ensure that the valuation method is appropriate for the particular business and the industry. The options include using a set value, the face-value of an insurance policy, an independent appraiser, or a formula that may include some combination thereof. Each of these options involves various pros and cons.
An insured buy–sell agreement is often recommended to ensure that the buy–sell arrangement is well-funded. This is particularly useful for a triggering event involving the death of co-owner as it guarantees there will be enough money for the buyout. In this situation, the company would be the sole beneficiary of a life insurance policy of each co-owner, and the company buys the deceased co-owner’s interest with the insurance proceeds. A buy-sell agreement can also be funded through cash in the business or through each owner’s personal assets. In practice, it will likely be funded with any of the above depending on the triggering event, as not all triggering events can be insured.
In conclusion, buy-sell agreements are a critical, yet often overlooked, succession planning tool for closely held business owners. They provide a source of liquidity to exiting owners or their families and help ensure the continuity of the business by maintaining control in the hands of the remaining owners.