By Bradley Hunt, Attorney at Law
What is a Buy-Sell Agreement?
If you share ownership of a business, you need a buy-sell agreement. Buy-sell agreements are not written when you are buying or selling a company; rather, they outline the rules under which an owner may sell (or be forced to sell) his or her share of the business. They also cover the disposition of this share of the business if the partner is divorcing, files bankruptcy, retires, becomes incapacitated, dies, or fails to meet an obligation to the business. Any of these triggering events may activate the terms of the buy-sell agreement. These agreements can be especially important in family owned businesses as protection for all parties involved.
How does a buy-sell agreement work?
The buy-sell agreement defines the terms and conditions that will govern transfer of ownership of an owner’s share of the business. In a partnership with three principals where one decides to retire and sell his share, for example, the two remaining partners would be notified of the exiting partner’s intent to sell. They would then be given the first option to purchase this share of the business back. In most cases, the share would be offered with an equal split to the existing partners. The agreement protects the remaining partners by preventing the third partner from selling their share to an outside party or even a competitor. If the third partner has died, the heir(s) may choose to keep the business but must typically abide by the terms of the buy-sell agreement should they wish to sell their share.
The selling price is usually determined based on a calculation defined in the buy-sell agreement. This protects everyone from a situation where the seller might demand an unreasonable fee or an immediate buyout to access cash quickly. When writing a buy-sell agreement, the partners should come up with a formula that is as objective as possible to determine the future value of the business and avoid misunderstandings or disagreements. (Note: you will need to consider the tax consequences of the valuation method and transfer method.)
In some cases, the value of the share of the exiting partner is too high for the business to afford. The buy-sell agreement should anticipate this contingency and allow for payment terms or an extended schedule of payments of some kind. You should also include terms defining what happens if the remaining partners are unable or uninterested in buying the share of the business.
Do buy-sell agreements apply to LLCs and corporations, too?
In short, yes. The above example references a partnership, but the same challenges can arise in an LLC or privately held corporation (buy-sell agreements are not common in publicly traded corporations). What happens if one partner dies and his voting shares of the corporation pass to his children? Are those children capable of stepping into his shoes and making decisions on how the business is run? A buy-sell agreement can define how this triggering event is handled based on input from the owners.
Buy-sell agreements provides protection to the owners. They are highly recommended to ensure the business continues as its owners intended. If you are considering starting a business with a partner, I recommend you speak to a business attorney to get a buy-sell agreement in place to protect each owner.