What Is A Buy-Sell Agreement, And Why Might You Need One?

Written by KPI

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 vital piece of succession planning, they are intricate and fine-tuned documents necessary to aid in proper division or dissolution of a company.

A buy-sell agreement, also commonly referred to as a 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.

Understanding What A Buy-Sell Agreement Accomplishes

As mentioned, the buy-sell agreement is a legally binding contract, and it helps the owner to accomplish his desires, at some unknown point in the future, if death or disability were to occur. Here are the key provisions:

  • Stipulates if an owner plans to dispose of their business interest where 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 he or she must sell his interest and also identifies the buyer and mandates he or 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, where necessary.
  • A systematic process to update business valuations and adjust insurance coverage should be outlined.

In essence, it aims to provide all the necessary direction, as well as provisions for updating, so both the current and future owners have no unanswered questions should this kind of resolution  event arise. You can quickly see how important it is to have it drafted legally, and properly.

Of course, there are positives and negatives to putting something so concrete into place.

Advantages of a Buy-Sell Arrangement

    1. Provides a smooth transition and continuity of management and ownership to the remaining business owners.
    2. Creates an instant market for a business interest that may not otherwise be sellable.
    3. Establishes a fair market valuation for federal estate tax purposes which is binding to the IRS.
    4. Spells put the terms of payment and is easily funded with life insurance and disability insurance, if desirable.
    5. Provides the liquidity to the retiring owner or to his estate in the event of death.
    6. Peace of mind and security for the business, the business owner’s and their families.

Different Funding Options Available

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.

The 3 Types of Buy-Sell Agreements

Buy-sell planning is an extremely important part of long term business continuation planning, but there are more than one kind you can draft.

The common types of buy-sell plans include the stock redemption agreement or entity plan, the cross purchase buy-sell agreement and the wait-and-see buy-sell agreement.

Stock Redemption Plan or Entity Plan:

An agreement between the company (Entity) and the business owners or partners whereby the owners agree to sell their ownership interest back to the company if they become disabled or wish to retire. If there is a death of an owner, the owner’s estate is required to sell the deceased owner’s interest back to the company.

Cross-Purchase Agreement:

A written agreement among the company partners or stockholders to purchase each other’s shares at the disability, retirement or death of a business owner.

Wait-and-See Buy-Sell Agreement:

An agreement allowing the business owners to delay the selection of an entity plan or a cross-purchase buy-sell agreement until an actual death, disability, retirement or sale of a business interest.

Which Type of Buy-Sell Plan is Best for My Company?

There is no one-sized fits all, so even these could be just an introductory on would need to be known to begin the process of drafting the document. The questions below will help you identify the type of buy-sell agreement that may best fit your business.

  1. How many business owners does the company have?
  2. How old are the individuals that own the business?
  3. Is each of the owners insurable?
  4. What are the ownership interests of each owner?
  5. What is the value of the business?
  6. Is this a family owned company?
  7. What is the potential tax impact for each option?
  8. What are the estate planning implications for each option?

The answers to each of these questions will provide insight into which plan will suit your business. Consulting with your business attorney and CPA or tax adviser is the only way to assure you address all potential concerns and choose the proper plan structure.

Additionally, to get a better idea of what one may look like in real form, here is a sample buy-sell document. Of course, it will vary depending the type chose, who drafts it, and what (as well as who) is all included.

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