What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract which protects the interests of the company’s owners and permits the business to continue in the event of the death, disability, or retirement of a business owner. A buy-sell agreement, commonly referred to as buy-sell arrangement, is drafted by an attorney and can be implemented with all forms of companies including, partnerships, limited liability companies, and corporations. A buy-sell plan can be thought of as a written agreement to help a business navigate a successful business transition.
Key Provisions of a Buy-Sell Agreement
- Stipulates that if an owner plans to dispose of their business interest that they must first offer it for sale to remaining owners or the business itself.
- The purchase price of a business owner’s interest is based upon a pre-determined formula to be used at the time of death or disability. This allows a definitive price to be set for the ownership interest.
- Identifies the seller and mandates that he must sell his interest and also identifies the buyer and mandates that she must buy the interest when made available.
- The agreement is based on a current business valuation which establishes the fair market value of the company and is the basis of the price and terms of sale when applicable.
- Funding mechanisms such as life insurance and disability
income insurance are noted.
- Specific instructions for handling the dissolution of the business.
- Valid reasons for termination of the agreement.
- A systematic process to update business valuations and adjust insurance coverages should be outlined.
For more specific details see the Sample Buy-Sell Agreement.
Buy-Sell Agreement Advantages
- Provides a smooth transition and continuity of management and ownership to the remaining business owners.
- Creates an instant market for a business interest that may not otherwise be saleable.
- Establishes a fair market valuation for federal estate tax purposes that is binding on the IRS.
- Spells put the terms of payment and is easily funded with life insurance and disability insurance, if desirable.
- Provides the liquidity to the retiring owner or to his estate in the event of death.
- Peace of mind and security for the business, the business owner’s and their families.
Buy-Sell Agreement Funding Options
Companies have several options to fund a buy-sell agreement in the event of a disability, death or retirement of a business owner:
Business Owner’s Personal Funds: Most business owners reinvest their money back into their businesses and therefore do not maintain large sums of available liquid assets on hand.
Finance the Purchase Out of Company Cash Flows: Also known as self insuring, this approach is equivalent to doing no planning at all. If a business owner dies or becomes disabled, in most cases, cash flows will decrease. Just when the need arises, the cash is not available to fund the terms of the agreement.
The Business Can Borrow the Funds: The business may be able to borrow the funds from a lender to fulfill the terms of the buy-sell agreement. The business can then pay back the lender over time thereby reducing the immediate financial impact. However, the loss of a key business owner will likely hurt cash flows and may also affect the borrowing ability of the company. Additionally, the additional interest expense may be excessive and burdensome over time.
Establish a Business Sinking Fund: Allows a company to accumulate the dollars needed over time. However, there are serious consequences if a business owner dies prematurely or sustains a disabling injury. In this case, the sinking fund would like be insufficient to honor the terms of the agreement.
Installment Sale or Payments: Similar to borrowing the funds except that the departing business owner or their heirs (seller) finances the buyer. The outgoing owner or her heirs must depend on the business to make principal and interest payments. If the business fails installment payments may cease.
Life insurance and Disability Income Insurance on the Owners: By far the easiest and most economical way to fund a buy-sell agreement is with life and disability insurance. Both life and disability income insurance can provide the liquidity to fund a buy-sell agreement at the exact time the funds are needed. If a covered business owner dies, a life insurance policy can guarantee that the liquid funds will be available to fulfill the terms of the agreement. At the same time, life insurance policies can also grow cash value that can be used to purchase a retiring partner’s interest. Finally, a disability buy-out policy can be secured to guarantee that funds will be readily available in the event of a long term disability to a business owner. Life and disability insurance policies are the perfect vehicles to cover potential business succession risks.