As a business owner, one of your primary concerns is overseeing the health of your business. Irrespective of the type of business you run or your role in the company, consider for a moment what would happen if one of your partners was no longer able to perform his or her duties effectively. In order to ensure the continuity of your business, you will need to have a plan in place which describes what would happen if you or one of the other co-owners has to leave the company. This is called a Buy Sell Agreement.
What is a Buy Sell Agreement?
Also known as a buyout agreement, the Buy Sell Agreement is a legally binding contract designed to deliver a detailed game plan for how the remaining co-owner(s) are to carry on in the event one of you leaves the business. This departure could be the result of a number of different factors, including retirement, desire to sell shares, disability, divorce, individual debt default or bankruptcy, disagreements among the owners, or death.
Why You Need One
Drafting a Buy Sell Agreement is a lot like drafting a living will. In fact, some refer to the Buy/Sell as a “business will.” It is designed to protect the company – to make sure important things are taken care of – if someone leaves. The Buy/Sell offers several key advantages to your business:
- It maintains the continuity of your business by making sure members get to decide what happens to the business before trouble arises.
- It protects company ownership by laying out a succession plan for departing members. This keeps remaining members from being saddled with untested successors (like the widow or offspring of the departing co-owner).
- It minimizes dispute between remaining co-owners and the family of the departing owner by having a strategy in place ahead of time to govern business operations.
- It alleviates co-owner stress and uncertainty by specifically identifying which events would trigger a buyout.
- It protects business assets and liquidity by providing a financial (and tax) plan for each of the different triggers addressed in the agreement.
- It protects the interest of, not just the business entity itself, but also that of the business owners to ensure members (and their families, in the event of death or disability) are handled with respect, courtesy and the utmost fairness.
What Should A Buy Sell Agreement Include?
Buy Sell Agreements are typically structured in one of two ways: cross-purchase or redemption. A cross-purchase Buy Sell Agreement allows remaining owners to buy out the ownership interest of the departing co-owner. A redemption Buy Sell Agreement (also called a repurchase) enables the business entity itself to reclaim the ownership interest of the departing owner. Both types of Buy/Sells have advantages and disadvantages. Deciding which way to structure your Buy Sell Agreement really is up to you. No matter which type of agreement you choose, it will need to address four key business issues: the succession plan, triggering events, funding sources and buyout price.
The first question your Buy/Sell Agreement should answer is this: Who can buy the departing owner’s shares or interest in the company? The loss of key personnel can be devastating for a business. It affects not only how the business is managed, but can also impact company sales, creditworthiness, market share and its overall market value. While this problem alone is generally more than enough for remaining owners to manage, the added hardship of suddenly having to protect the company from intruders who have bought shares in the company – quite possibly to its detriment – complicates issues even further.
What will trigger the buyout? Triggering events guarantee owners that upon the occurrence of specific events their shares of stock will be bought out. Some of the most common reasons for buyout are disability, divorce, debt and death.
Disability. An owner who has become disabled and is no longer able to perform his or her duties may need to be bought out in order to protect the integrity and liquidity of the company. The Buy Sell Agreement should specifically define what constitutes a disability. Generally, disability payments are remitted as a percentage of a worker’s regular salary for a predetermined amount of time. What can your business afford? Clearly outline how much that payment should be and the length of time the owner can expect to receive those payments before being bought out.
Divorce. An owner who is in the midst of a divorce may be bought out to protect the company’s ownership. It’s not uncommon for a family law judge to order a business owner to split his or her interest in a company with the former spouse. A clause which ensures the former spouse will sell those shares back to one of the company’s original owners or to the company itself can protect your company from being torn apart.
Debt. Credit isn’t easy to come by and a blow to your company’s credit rating can result in thousands of dollars in unnecessary fees being levied on your business. Particularly for small businesses, individual owners are often on the hook as personal guarantors for any and all business debt. A co-owner or shareholder who defaults on a company loan or who is not in a financial position to make payments to the business for corporate loan repayment can compromise the financial health of the entire business.
Conflict. Management issues that cannot be settled between the owners may bring your business operations to a screeching halt and subsequently trigger a buyout of individual stakeholders. The way in which that buyout is to be handled should be outlined in your Buy Sell Agreement.
Retirement. Whether it is a voluntary early termination or typical departure, retirements should trigger a buyout. The amount paid for shares in an early retirement may differ from those paid out for regular retirement, but the remaining shareholders will definitely want to reclaim that interest in the business.
Death. The death benefit paid to the family of a deceased owner is going to be the largest buyout payment of any of the afore-mentioned triggering events. It is often the case that key personnel / co-owners are covered by company-paid life insurance policies which are issued with a face value equivalent to the buyout price. If a shareholder dies, the life insurance policy pays the company and the company buys shares back from the decedent’s family.
Where will the money come from to complete the buyout? Are the individual owners responsible for initiating the buyout or will the company be used as the funding source to buy out a departing co-owner? Businesses often have insurance policies in place to cover the expenses of funding a buyout when necessary.
What’s the price of the buyout? Buyout prices vary depending on the buyout trigger and market conditions. Company appraisals can help ensure the company does not overpay for shares as well as ensure beneficiaries are not underpaid for their shares. Each trigger could have a fixed price. For instance, a co-owner who is considering selling his or her interest in the business to a third party investor will likely receive a buyout offer that matches the price being offered by that third party. A buyout price for the death of a co-owner will be different from the price of a buyout that results from retirement. Not only that, but the payment terms will differ as well. A death benefit would likely see a lump sum payment funded by an insurance policy while a mandatory retirement buyout would probably trigger smaller installment payments occurring over time.
The rule in business is always to prepare abundantly before. You can’t predict the future and often, you can’t stop hard times from touching your business. You can do what’s necessary to minimize its impact, however.
If you are thinking about starting a business, and can afford one, having a seasoned business or tax attorney sit down with you and your partners to draft a Buy Sell Agreement can be some of the best money you will ever spend.
If money is too tight to pay an attorney for a buy sell agreement (normally $1000 or more), then we recommend using RocketLawyer’s Buy Sell Agreement Wizard which you can find here.
Don't forget to check out LegalZoom for your online legal service needs.