When you establish a business partnership, you don't intend for it to dissolve. Unfortunately, many circumstances – new opportunities, disputes, death – can sever a partnership. That's why creating and signing a buy-sell agreement is important for all business partners. What is this contract, and what does it cover? Read on to learn more.
What is a buy-sell agreement?
A buy-sell agreement, also known as a buy-and-sell agreement, is a contract that determines how a partner's shares in your company are reassigned if the partner departs, dies or otherwise ceases their ownership in your company. Usually, your buy-sell agreement will state that the partner's shares should be sold to your company's other partners. Additionally, buy-sell agreements often lay out a valuation process for your business.
How does a buy-sell agreement work?
A buy-sell agreement establishes how your company will go about receiving the shares that a departed partner leaves in their absence. Buy-sell agreements are most common among companies set up as partnerships, as they create a binding mechanism for a partner to exit the company. Some sole proprietors also create buy-sell agreements to determine who can buy their business in the event of their death.
Buy-sell agreements exist for more than convenience. If your company has more than one owner, you are legally required to draft a buy-sell agreement. Often, your agreement will include a formula that determines how a departed partner's shares will be sold back to your company.
This formula can be especially helpful in the event of a partner's death. In this case, the partner's estate is responsible for executing the agreement, with which it may not have been previously familiar.
Types of buy-sell agreements
Buy-sell agreements come in three types:
- Cross-purchase. If you and your business partners sign a cross-purchase agreement, you and your other partners would buy a departing partner's shares.
- Stock redemption. If you and your partners sign a stock redemption agreement, then your company will buy the departing partner's shares. With the departed partner's shares in the company's possession rather than that of the remaining partners, the shares could be sold to anybody (as long as your company is incorporated accordingly).
- Combination. Not all buy-sell agreements distinguish between cross-purchase and stock redemption arrangements. In these combination agreements, you and your partners will buy a portion of the departing partner's shares, and your company will buy the remaining portion.
Notably, none of these arrangements guarantee that you and your partners have enough money to buy the departing partner's shares. That's why, in some cases, partners take out life insurance policies on the other partners. This way, if a partner's death triggers the buy-sell agreement, the other partners can use the proceeds of their life insurance policies to buy the deceased partner's shares.
Buy-and-sell agreement FAQs
At this point, you might feel like buy-sell agreements are pretty straightforward. However, like any contract, buy-sell agreements can be more complex than they seem. Here are some answers to frequently asked questions about buy-sell agreements.
What are the key elements of a buy-sell agreement?
These are generally the most important elements of a buy-sell agreement:
- A valuation clause. This clause clearly states your company's value or provides a formula to determine this value based on several variables. A professional appraisal, though expensive, may also be in order.
- A clear indication of the parties involved. Your agreement should clearly state the names of all the partners covered by your buy-sell agreement. It's best to list the names near the top of the agreement and again in the signature area at the bottom.
- Buyer funding options. As mentioned earlier, partners sometimes take out life insurance policies on other partners to ensure ample funds for buying a deceased partner's share. Your buy-sell agreement should include language detailing this approach and any other buyer funding methods you'll use.
- A list of qualifying events. A partner's departure is not the only scenario where you'd have to turn to your buy-sell agreement – your agreement should list all the possible reasons for using it.
- Tax obligations. Share purchases and sales are often taxable, but you can minimize your tax liabilities with careful planning. As you draft your buy-sell agreement, you should consult a CPA, who can advise you on clauses you should include to improve your tax situation in the event of a partner buyout.
How much does a buy-sell agreement cost?
Although there is no single standard cost for the drafting of a buy-sell agreement, you should expect to pay several thousand dollars in lawyer's fees. Your costs will depend primarily on the number of partners included in the agreement, though other factors may affect your costs as well.
How do you value your company during a transfer of shares?
It's best to value your company before you draft your buy-sell agreement, rather than while you transfer shares. To do so, you can either hire a professional appraiser or develop a variation formula that you include in the agreement. Both options circumvent the challenge of partners independently valuing your company upon a buyout and coming up with different numbers.
What happens if a company or its partners can't afford to buy a departing partner's shares?
Not much can be done if a partner departs and the company or remaining partners can't afford to buy that partner's shares. However, you can plan ahead in the terms of your buy-sell agreement.
You should add details about flexible payment plans to your buy-sell agreement. With flexible payment clauses in your agreement, you allow your company or its partners to put down initial deposits on share payments and then cover the remainder of the purchase in installments. Such installment-based payment plans can span several years, and they often include interest payments.
Can a partner's bankruptcy have an effect on the business?
Yes. If one of your partners files for bankruptcy, there is a chance your business could be sold to cover their debts. However, your buy-sell agreement can prevent this scenario.
In your buy-sell agreement, you can include a clause that requires a partner to notify all other partners before filing for bankruptcy. This notification becomes an opportunity for the remaining partners to buy the bankrupt partner's shares, so your company can operate unencumbered by bankruptcy concerns.
Can a partner's divorce have an effect on your company's share ownership?
Yes. In states with community property laws, divorcing spouses can seek any earnings acquired during the marriage or any property, including business shares, purchased with these earnings. Divorces in states without community property laws can still present business ownership challenges, as a divorcing partner's spouse can still seek business shares as part of an equitable property division.
As with the other concerns in these buy-sell agreement FAQs, you can mitigate divorce-related concerns with a well-written buy-sell agreement. You should include a clause in your agreement that requires a divorcing partner's spouse to sell business shares they receive in the divorce back to your company or its partners. A valuation formula or amount in the agreement can hasten this sell-back process.
How do buy-sell agreements relate to estate taxes?
In the event that a partner dies and leaves their shares to their kin, the deceased partner's estate taxes will be a flat proportion of their shares' values. As such, a lower valuation in a buy-sell agreement would mean estate taxes will be lower upon a partner's death.
How often should buy-sell agreements be amended?
Your lawyer should review your buy-sell agreement every year. If certain provisions are no longer legal or your business's structure changes, you can revise your agreement appropriately. This also gives you an opportunity to revalue your business while considering all the above factors. Annual reviews allow you to set up smoother partner buyouts.
Though often challenging, partner departures don't have to put your business in an impossible situation. Buy-sell agreements can make the transition easier when the time comes.