When entrepreneurs agree to go into business together, they are typically excited about the prospects of their mutual business relationship and are very amicable upon the onset of the endeavor.
However, at some point in the future one or more owners will inevitably depart from the business. By having a properly structured buy-sell agreement, the owners will be able to ensure a smooth and orderly transfer of ownership interests.
When it comes to transferring or selling a small to mid-sized private company or business, there are important things to consider:
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract used by small to mid-sized businesses to outline how ownership interests (shares, partnership stakes, or membership interests) will be handled if a triggering event occurs.
We’ll get to the “triggering events” further below.
Why Have a Buy-Sell Agreement? What’s its Purpose?
First and foremost, a buy-sell agreement will document the best way to transfer ownership while all of the owners are still engaged and active in the business.
The primary purpose is to ensure the smooth continuity of the business by:
1. Facilitating Business Transfers or Changes
A properly-structured buy-sell agreement outlines how shares of the business will be bought or sold during an ownership transfer. It will outline which stakeholders in the agreement have the right or obligation to buy the shares (for instance, other owners or the business itself).
Private company ownership transitions that occur during highly emotional times — such as a partner’s death or divorce — can be contentious. A buy-sell agreement reduces conflict by outlining ahead of time who will buy the departing owner’s shares and the timeline for the process.
2. Setting a Valuation Methodology
Next, a good agreement details how the the shares of the business will be accurately valued. A good buy-sell arrangement will include the details of a fair and predetermined process to value the ownership stake — all intended to minimize conflicts when selling or buying shares of the business. For example, the agreement might state that the valuation will be based on a multiple of EBITDA or an independent appraisal to ensure fairness.
Disputes over the value of a business are common when ownership changes hands. Without a predetermined valuation process, negotiations can become long and frustrating, sometimes leading to legal disputes.
3. Protecting Stakeholders Involved in the Agreement
A buy-sell agreement provides peace of mind to all parties by defining how ownership transitions are managed and protecting the interests of both the remaining owners and the departing shareholder.
For example, if a partner passes away, the buy-sell agreement can ensure their heirs receive a cash payment rather than being forced into ownership or ongoing involvement.
4. Ensuring Funding Has Safeguards
Without a clear plan for financing the purchase of shares, buyers might struggle to gather the necessary funds, leading to delays or legal battles. Funding mechanisms like life insurance, savings, or installment payments can resolve this issue.
For example, if an owner dies, a life insurance policy funded by the business can provide the necessary cash to buy out the deceased owner’s shares without draining company resources.
The 5 D’s of Buy-Sell Agreement Transfer Events
A buy-sell agreement details how shares, partnership stakes, or membership interests will be handled if a triggering event occurs. A properly structured buy-sell agreement will address ownership transfers for unanticipated business departures, which are commonly referred to as the 5 D’s of triggering events: death, disability, distress, divorce, and disagreement.
Each of the D’s are geared to protect the many individuals who are impacted by an ownership interest within a privately-held business.
For example, the widow(er) of an owner needs to be protected in the event of a death. Likewise, the remaining owners need assurance that the ownership can be redeemed by the business.
1. Death
It should be clear what will happen to the ownership interest upon the unfortunate death of a business partner. The remaining owners will likely not want to be business partners with the spouse or the estate’s heirs.
2. Disability
What happens if someone is no longer able to work? In many cases, business owners are required to be actively working to be an owner. The buy-sell agreement should spell out what will happen if an owner is no longer able to work due to injury or illness.
3. Distress
Similar to disability, an owner may not be able to work due to a difficult personal situation (e.g., taking care of a sick loved one) and it is important to include provisions that will protect the company and the owner in this type of circumstance.
4. Divorce
This consideration applies directly to businesses that are owned by a married couple. A successful business should not be harmed in the event a marriage ends.
5. Disagreement
It is not entirely out of the question that business partners may someday no longer want to be in business together. In these unfortunate circumstances, a buy-sell arrangement is instrumental in maintaining an orderly departure while emotions are typically riding high.
What Types of Businesses Should Have a Buy-Sell Agreement?
Essentially, any business with more than one owner needs a buy-sell agreement. It does not matter if the business is a corporation, partnership, or LLC. As long as there are multiple owners, you should ensure that a buy-sell agreement is in place.
Even businesses which are entirely family-owned should have such agreements; without one, family relationships can be damaged due to a lack of clarity in ownership transitions.
What Should a Buy-Sell Agreement Include?
A basic buy-sell agreement should include the following items:
- A reliable process for how ownership can be transferred
- Who does and does not have the right to buy an ownership stake
- How to value the ownership interest for a departing owner or for estate tax purposes
- What happens to the ownership interest in the event an owner passes away
- How ownership redemptions are financed or paid for
- Provisions to remove owners under certain circumstances
- Other governance provisions to ensure business continuity
Depending on the type of entity, the provisions of a typical buy-sell agreement may be included or take form in a different document. For example, a partnership may include such provisions within its partnership agreement, and the same may be true with a shareholder agreement for a corporate entity. Nevertheless, it is critical to check these agreements to ensure that buy-sell provisions are in place.
Creating & Managing a Buy-Sell Agreement for Your Privately-Held Small to Mid-Sized Business
Regardless of the form a buy-sell agreement takes, it is prudent to regularly review the agreement and ensure that it is up-to-date. As businesses grow and evolve, it is not uncommon for buy-sell agreements to need amendments from time to time.
Thinking about creating a buy-sell agreement yourself? Here are some things to consider when developing formulas for valuing your company.
If you need assistance with reviewing, updating, or creating your buy-sell agreement, please contact us or explore our Transition & Exit Planning Services page.
Additionally, we offer more auditing and accounting services for small to mid-sized businesses.