Buy-sell agreements are an essential tool for businesses with more than one owner. This type of agreement spells out what will happen to the departing owner’s share of the business if they leave the business.
It is never a good idea to wait until there’s a problem or a period of transition to discuss a buy-sell agreement. By planning ahead, you can reach an agreement while all owners are on the same footing. This is important because it can be difficult to negotiate after a triggering event occurs.
This article will discuss the benefits, key components, and important considerations of a buy-sell agreement.
What is a Buy-Sell Agreement?
A buy-sell agreement is a contract among owners of a company that outlines how an owner’s interests can be transferred to a buyer if a triggering event occurs. A triggering event may be the owner deciding to sell their interests, leaving the company, dying, or becoming incapacitated. The agreement defines how the equity interests will be valued and who will have the right to purchase the owner’s shares.
Buy-sell agreements streamline situations where at least one owner of a multi-owner business leaves – whether it’s due to death, incapacity, retirement, or other reasons. This agreement typically stipulates that the departing owner will sell their shares back to the remaining owners at a price based on a predetermined formula, and it may also include provisions for how the purchase will be funded. The price is typically determined by (1) having an appraiser determine the full market value of the business, (2) a predetermined agreed-upon value, or (3) using a predetermined formula.
Often, buy-sell agreements are funded by life insurance policies that provide the cash needed to acquire the departing owner’s shares in the event of their death. This is important because, without the liquidity provided by an insurance policy, the remaining shareholders might be forced to deplete current assets or borrow money under unfavorable terms. This could jeopardize the business’s financial stability and make it difficult to continue operations.
While a buy-sell agreement is not required by law, it is a critical tool for protecting the interests of all owners of a business. Buy-sell agreements provide clarity and certainty in an otherwise potentially chaotic situation. For the departing owner, a buy-sell agreement ensures they will receive fair value for their shares. For the remaining owners, it ensures they will not have to deal with the departing owner’s heirs or other third parties. In addition, buy-sell agreements can help prevent owners’ disagreements about who should own the business, as they provide clear guidelines about how ownership can be transferred.
Types of Buy-Sell Arrangements
There are two main ways to structure a buy-sell agreement: a cross-purchase agreement or an entity purchase agreement.
Under a cross-purchase agreement, each owner agrees to buy out the other owner’s share of the business in the event of their death, disability, or departure. The purchase is typically financed through a life insurance policy, a loan, or personal funds.
If using life insurance, each owner would purchase a life insurance policy on the other owner. For example, John and Tom own a business together. Based on the business valuation, they each agree to purchase a $1 million life insurance policy for the other party. John purchases a life insurance policy on Tom, wherein John is the beneficiary, and Tom purchases a policy on John, wherein Tom is the beneficiary. The insurance policies have riders that cover illness, incapacity, or disability. If one owner must depart the business for any covered reason, the remaining owner can rely on the cash value of the life insurance policy he previously acquired to buy out the departing owner’s share of the business.
A primary benefit of using life insurance with a cross-purchase strategy is that the insurance proceeds are generally income tax-free for individuals, whereas if a C-corp business owns the policy, the proceeds may be taxable. However, using life insurance can be impractical for businesses with many owners, as it would multiply the number of life insurance policies to purchase and manage. Another potential issue with life insurance is the possible discrepancy in age between the owners. If one owner is much older, their policy could be more expensive – creating an imbalance in policy costs between multiple owners.
Entity Purchase Agreement
Under an entity purchase agreement, the business agrees to buy out the other owner’s share of the business in the event of their death, disability, or departure. Like a cross-purchase agreement, the purchase is typically financed through a life insurance policy, a loan, or corporate funds.
If using life insurance, the business buys the policies and uses the proceeds to purchase the departing owner’s shares. Essentially, the business will be the owner and beneficiary of life insurance policies for all the owners. For example, Acme Corp has five equal owners and is valued at $5 million. Acme Corp takes out a $1 million insurance policy on each owner, of which Acme Corp is the beneficiary. If an owner must depart the business for any covered reason, Acme Corp can use the cash value of that owner’s life insurance policy to buy their shares.
This structure may be more practical for companies with several owners. However, if using life insurance, be aware that the insurance proceeds will need to be reported as income on the business’s tax return. And unfortunately, the premiums are not tax deductible. Additionally, C corporations may be subject to the alternative minimum tax for the life insurance proceeds if and when a triggering event occurs.
What are Some of the Key Components of a Buy-Sell Agreement?
Trigger events are any event you want to “trigger” the terms of the buy-sell agreement. They can include retirement, incapacity, disability, death, and voluntary departure, among others. You can also include terms that allow for the involuntary removal of an owner, for instance, if that owner is no longer able to perform their duties but does not voluntarily depart. In fact, a well-crafted buy-sell agreement will consider as many “what-ifs” as possible to smooth the transition for any eventuality.
One of the most critical components of a buy-sell agreement is the valuation of the business and each shareholder’s interest. This portion of the agreement aims to reduce conflicts between departing and remaining owners (and potentially their families) regarding their stake in the company.
In this section of the agreement, it’s important to devise a methodology for valuing the company in the future. For example, the owners may decide to obtain three different valuations and find the average value of the company based on the three valuations. The owners may also work with their accountants to determine a formula for valuing the company. If the owners opt for this valuation method, it is important to include language to ensure the formula does not become stale.
Either way, this section must be carefully crafted with precise language because terms could be defined differently by the business’s owners, accountants, lawyers, and ultimately the courts.
That said, business owners should consult with experienced attorneys and accountants when drafting their buy-sell agreement, particularly when deciding on the valuation method. This is the best way to ensure the agreement meets the needs of all the owners and protects the business’s interests.
Financing and Payout Terms
Once a valuation method has been determined, owners will need to consider how a payout will be financed, if at all. For example, the agreement may stipulate that 20% of an owner’s shares will be paid at closing, with the remaining 80% paid over time with interest.
If the owners opt to finance a portion of the buyout, they will need to determine the length of the term and the interest rate. And given that buy-sell agreements may not come into play for years, it’s wise to avoid a fixed interest rate. Rather, it is best to stipulate that interest rates follow the applicable federal rate at the time of closing.
This portion of the agreement should also reference any life insurance policies acquired to fund the buyout.
What Should You Consider When Drafting a Buy-Sell Agreement for Your Business?
While buy-sell agreements can help protect the interests of all parties involved, they can also be a source of conflict if they are not drafted correctly with clear and unambiguous language. This cannot be emphasized enough, as ambiguity or minor discrepancies can lead to conflict about the required procedures and value of the business after a triggering event. Such conflict can result in costly litigation and animosity between the parties. To avoid these pitfalls, business owners should consult with attorneys and accountants to ensure that the agreement’s language matches their intentions.
Second, buy-sell agreements are not something to set and forget. They must be reviewed periodically to ensure the agreement still meets everyone’s goals. Likewise, the business should be valued regularly to ensure the sufficiency of any life insurance policies that will fund a potential buyout.
The best way to ensure your buy-sell agreement is expertly crafted and suits your business’s needs is to meet with experienced professionals who understand the complexities of these types of contracts.
This article is intended to provide a brief overview of buy-sell agreements and is not a substitute for speaking with one of our expert advisors. If you’d like to speak with one of our advisors about a buy-sell agreement for your company, please contact our office.