Buy-sell agreements are legally binding documents between business partners that govern how business interests are treated if one partner or owner leaves the business unexpectedly. A buy-sell for small business owners is a practical approach for safeguarding a company, customers, employees, and other stakeholders.
Events that may trigger a buy-sell agreement include:
- Employment termination or resignation
- Permanent disability
- Death of an owner
How Buy-Sell Agreements Work
Buy-sell agreements are in place to protect a company’s longevity. If a vital member of the company leaves, there needs to be a process that directs shareholders and remaining partners how to proceed with a transfer of ownership.
Here is how buy-sell agreements work:
- Step 1. Determine which events invoke a triggered buyout
- Step 2. Establish who has rights and purchase obligations
- Step 3. Identify the names and address of the purchasers
- Step 4. Set a purchase price or valuation method
- Step 5. Establish payment terms for the sale and purchase
- Step 6. Decide on the consequences of not using purchase rights
- Step 7. Set an assignment of shares and how they’ll be distributed
Types of Buy-Sell Agreements
Selling your business shares upon a triggering event is a significant legal issue to consider when you own a business. Types of buy-sell agreements include
- cross-purchase agreements,
- redemption agreements,
- hybrid buy-sell agreements,
- company purchase agreements, and
- Asset Purchase Agreements
Consider your options carefully when engaging in a buy-sell agreement and speak with an attorney to learn about your legal rights.
Cross-purchase agreements permit company shareholders to purchase the stocks of a partner when a triggering event occurs. It often hinges upon a life insurance policy so that something of value can be exchanged. These types of buy-sell agreements are often used in business succession planning.
Redemption agreements require the company to redeem the deceased or disabled partner. They return the stock ownership to the corporation as payment under the buy-sell agreement. Payments are funded through the disability or life insurance of the deceased or disabled partner.
Hybrid Buy-Sell Agreements
Hybrid buy-sell agreements, also called wait-and-see agreements, usually involve an option for shareholders and corporations to acquire shares after a triggering event. They allow the company to postpone selecting a cross-purchase agreement and a stock redemption until later. This option provides flexibility to the remaining company owners.
Company Purchase Agreements
Company purchase agreements are essential for transferring the ownership of a business upon a trigger event, such as death or disability. They generally contain the terms and conditions of the sale, including obligations, warranties, and liabilities.
Asset Purchase Agreements
Asset purchase agreements may fall under a buy-sell agreement when business transactions include the transfer of assets, such as property, real estate, and equipment.
Key Elements of a Buy-Sell Agreement
Buy-sell agreements contain several essential sections and provisions that clarify how the situations should be treated. Like most contracts, they have definitions clauses, acknowledgments, and more. What makes them unique are the terms around triggering events, payouts, and valuation.
The key elements of a buy-sell agreement include:
- Identify the parties
- Triggered buyout event
- Buy-sell structure
- Company valuation method
- Funding resources
- Taxation considerations
Your agreement may require additional sections, schedules, and attachments.
Who Needs a Buy-Sell Agreement?
Buy-sell agreements are typically used by business partners. However, a sole proprietor and a limited liability corporation (LLCs) may use them as well. Consider drafting buy-sell agreements anytime there are concerns over a critical partner leaving the business unexpectedly or through retirement.
The following types of business may be good candidates for buy-sell-agreements:
- Law firms
- Dental Offices
- Doctor’s offices
- Physical therapists
- Auto mechanics
- Local retailers
- Any startup or business with partners
Why You Need Buy-Sell Agreements
Several primary advantages exist when using a buy-sell agreement for your business. However, they broadly safeguard the rights and privileges of all parties when executed correctly. You will achieve a better result if you hire corporate lawyers to draft and negotiate the deal on your behalf.
Your business may need buy-sell agreements for the following reasons:
- Maintain business continuity
- Protect company ownership
- Mitigates the chance of dispute
- Relieves stress from the partnership
- Protects business assets
- Protects business owners and the business
Buy-sell agreements ultimately alleviate the concern over what happens if a partner leaves the business suddenly or retires. It is not a document you will refer to regularly, but it will offer a set of instructions if specific events occur.
Who Drafts the Buy-Sell Agreement? Contract lawyers will draft the buy-sell agreement. They can work with on behalf of the organization when drafting, negotiating, and executing the terms. It is recommended that each partner retain their counsel when entering into this type of contract
Common Buy-Sell Agreement Mistakes
Mistakes when using a buy-sell agreement in your business could lead to legal issues down the road. It is better to thoroughly discuss the particulars of the contract with your partner, company, and shareholders and review it annually to ensure that it still meets your business goals and needs.
Common buy-sell agreement mistakes include:
- Not coordinating with the other parties
- Failing to select the proper buy-sell agreement
- Inadequately identifying triggering events
- Not accounting for provisions once the event triggers
- Using the wrong valuation methodology
- Not dealing with funding issues before signing the agreement
- Failing to properly establish the agreement’s financing terms
- Inadequate coordination of related property
- Using a template from a different transaction
- Not evaluating and updating the buy-sell agreement
- Not including real estate in the transaction
As you can see from the above-referenced list, there are several areas where legal errors can arise during the negotiation and drafting process. Plus, you need your document to comply with local, state, and federal rules for it to be enforceable. Unenforceable agreements don’t protect your rights or business.
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This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.
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Echelon Financial is a member firm of The Fiduciary Alliance, LLC which is an Investment Adviser registered with the Securities and Exchange Commission. The Fiduciary Alliance’s business operations, services, and fees is available at the SEC’s investment adviser public information website www.adviserinfo.sec.gov or from The Fiduciary Alliance upon request.