A buy–sell agreement, or a buyout agreement, is a contract between co-owners of a business that addresses the situation if a co-owner is, for any imaginable reason, no longer a part of the business. For example, if a co-owner wants out of the business, wishes to retire, goes bankrupt, becomes disabled, gets divorced, dies or simply wants to sell his shares to someone else, a buy-sell agreement is, in essence, a premarital agreement or a “business pre-nup” between all the business partners or shareholders governing what should be done in such circumstances. This forces the business owners to talk and set guidelines for the process before it happens, to avoid expensive litigation if a dispute arises.
Every business with multiple owners should have a buy-sell agreement. Without plans written in stone for all future transitions, owners are playing a game of financial Russian roulette. As soon as these incidences occur, it is in everyone’s best interest to deal with the change and move on with, or without, the business.
Buy–sell agreements consist of several legally binding clauses. Sometimes they appear as a component of an operating agreement, other times they stand as a separate document. The standard clauses denote who is eligible to purchase a departing partner’s ownership interest. Most of the time this is limited to other owners, but sometimes it includes outsiders or relatives.
Clauses within the Buy-Sell Agreement
One of the most common clauses indicates the buy-out triggers, such as a partner’s death, divorce, bankruptcy, etc. We’ll discuss those triggers in more depth in a separate post.
Price can also be pre-negotiated, or the co-owners can agree on a valuation method, such as asking the company’s accountant, and what price or value is assigned to the former partner’s interest. Hiring an appraiser or using a valuation formula to put a price on shares or stakes is crucial before drafting a buy-sell agreement. To alleviate the stress of different valuations derived from different methods, it helps that the owners to agree on a way to value the company in advance.
Fund Your Buy-Sell Agreement with Life or Disability Insurance
Finally, most buy-sell agreements should be funded by insurance. If you’re a 50% co-owner in a business valued at $500,000, and the buy-sell has been triggered, you’ll have to come up with $250,000 in cash to purchase your partner’s share. That’s usually easier said than done, and sometimes means you have to sell the business because you cannot fund the buy-sell. That’s why you should fund your buy-sell agreement with insurance.