MLR

Understanding the Buy-Sell Agreement

business agreement handshake

Maybe you’re starting out and wondering to yourself, “how does a buy-sell agreement work”? If, however, you’re a business owner, you’ve probably established a buy-sell agreement in case you or a partner part ways with the company, whether voluntarily or involuntarily. Either way, it’s important to remember that just drafting an agreement and putting it in storage isn’t enough. From time to time, you may need to review the agreement and make revisions as needed.

Cover the Issues

The main reason for creating such an agreement is to grant the business owner the right (or obligation) to purchase the existing owner’s interest. Ideally, the agreement can also help to prevent control of your business from falling into the hands of anyone except specified individuals, such as current owners, upper-level managers, or family members.

Another reason to create a buy-sell agreement is to determine a price for ownership interests. During the initial drafting of the agreement, it’s prudent to work with a qualified appraiser to find an accurate value for the interests.

Additionally, you should confer with the appraiser periodically so you can be sure that the price remains accurate as the value of the company shrinks or grows. The agreement may also cover estate planning, and if your agreement is more than a few years old, it may need to be updated in relation to the most recent changes in gift and estate taxes.

Events that Cause Change

It’s normal for a buy-sell agreement to remain untouched for years at a time. A triggering event is an occurrence that causes the agreement to be resuscitated immediately. These may include situations where the current owner passes away, becomes disabled, or leaves the company voluntarily to either retire or pursue other ventures.

Some other less common triggering events you may want to consider include conviction of a crime, loss of a professional certification or license, or involvement in a scandal. Changes in the owner’s marital status may also need to be considered when drafting this type of agreement.

Agreement Structures

A buy-sell agreement is generally structured as one of the following three agreements:

  1. Redemption allows or demands that the business as a whole repurchases the departing owner’s interest
  2. A cross-purchase allows or demands that the remaining owners purchase the departing owner’s interest (usually on a pro rata basis)
  3. Or, a hybrid agreement combines both structures. For instance, the departing owner may offer to sell to the company, and if the company declines, they may sell to the remaining owners.

As you determine the right structure for your agreement, be sure to consider the tax implications, as they will vary depending on whether your company is a C corporation or a flow-through entity.

Funding Sources

A buy-sell agreement requires a funding source, as the remaining owners need to be able to purchase the departing owner’s shares. The most common is generally life insurance, but there are other options available too. If your company is doing well, you may be able to simply use your reserves. However, this can be a risky move, as it reduces your cash flow liquidity, leaving you vulnerable to unforeseen financial situations.

Another approach is to create a “sinking fund.” You can accomplish this by putting money aside that’s used to pay out the agreement over a period of time. This approach can also cut into your company’s cash flow, so you may want to avoid this buy-sell agreement strategy unless you’re confident in your company’s ability to continue generating revenue.

Gain Peace of Mind

Maintaining your agreement requires ongoing vigilance. However, it’s important to remember that preventing future conflicts is well-worth the time and effort if a triggering event should happen. After all, if you’re not prepared, you’re going to end up spending a whole lot more time, effort, and money if you don’t have a contract already in place and ready to go. If you haven’t already created a buy-sell agreement, there’s no better time than now. Contact Maxwell Locke & Ritter to find out how we can help!