Buy-sell agreements typically aren’t the first thing partners discuss when forming a business. Nevertheless, it’s important to have a formal exit strategy in place when there are multiple business owners in an organization.
According to the Small Business Administration, The United States is home to over 30 million privately held small businesses, of which over 6 million have multiple employees. Many of these companies are owned by older individuals and stand to be either sold or passed down to another generation. This setup may present some legal challenges for companies with multiple owners if they don’t have a buy-sell agreement in place.
Ideally, the time to put a contract in place is when the business is set up—not when ownership must change hands. But the good news is it’s not too late. If succession planning is part of your 2022 business goals, here’s what you need to know about buy-sell agreements.
What Is a Buy-Sell Agreement?
Essentially, a buy-sell agreement is a contract between business partners. It details when owners of a company can sell their interest, who can buy their shares, and the price for those shares.
The agreement typically comes into play when an owner becomes disabled, retires, dies, goes bankrupt, or gets divorced. It protects the remaining owners from potential buyers who may disrupt the business.
A strong contract may contain some (or all) of the following provisions:
- Call rights
- Put rights
- Deadlock provisions
- Right of first refusal
These rights give all owners various options to ensure a smooth transition when an owner decides to leave the company, or an event triggers the buy-sell agreement.
Why Are Buy-Sell Agreements Important?
A buy-sell agreement is important because it protects the remaining partners from joining their ownership interest with someone who may not have the same vision for the company. It’s similar to a prenuptial agreement but for business partners.
How Do Buy-Sell Agreements Work?
An experienced attorney typically draws up a buy-sell agreement at the time of the formation of the business partnership. All co-owners meet with the attorney to discuss the terms of the agreement and decide what events would trigger it.
The agreement’s overall goal is to minimize disagreements between the co-owners upon the departure of an owner. In addition, it provides direction for the remaining co-owners to transfer the interest of the owner who is leaving. A business valuation specialist, CPA, and/or financial planner should also review the agreement to ensure it makes sense from a financial and tax perspective.
Buy-sell agreements take many forms, but most fall into one of two structures: an entity-redemption plan or a cross-purchase plan. With an entity-redemption plan, the business entity is obligated to buy out or redeem the ownership interests of the departing owner. On the other hand, a cross-purchase plan means each surviving owner agrees to buy a specific percentage of the departing owner’s interest.
It can be helpful to create a buy-sell agreement at the time of the business’s inception. That way, it’s more likely that partners are on good terms and will handle the agreement fairly. Conversely, tensions can arise between partners if a co-owner unexpectedly departs, depending on the cause for the departure. This can lead to litigation or arbitration proceedings–an expensive undertaking that can negatively impact the business.
Funding a Buy-Sell Agreement
If the agreement is triggered, that means money needs to change hands. Therefore, it’s important to know where that money is coming from when you develop a buy-sell agreement. Cash, a sinking fund, installment payments, or taking out a loan are all potential funding sources. However, many business partners fund their buy-sell agreement with life insurance, as it tends to be a more cost- and tax-efficient funding strategy.
Advantages of Buy-Sell Agreements
Having a buy-sell agreement in place has many potential advantages, including:
#1: Having a Succession Plan in Place
Having a formal succession plan in place should reassure any business owner involved in a partnership. If a triggering event occurs, the remaining partners have a legal document that details how to treat the departing owner’s shares. This can help the business avoid the risk of litigation or arbitration, which can wreak havoc on a small business.
#2: Inexpensive Way to Protect a Company
Compared with the costs of litigation or arbitration, setting up a buy-sell agreement is a relatively inexpensive way to ensure a smooth transition when changes in business ownership occur.
#3: Estate Liquidity
In the event of a death, the business can liquidate the prior owner’s interest to assist with taxes, debts, and other estate settlement costs.
#4: Potential Greater Access to Capital
Having a formal buy-sell agreement in place may make you more attractive to potential investors and creditors. Otherwise, they may not be willing to extend capital if there’s a potential risk of future litigation.
Potential Disadvantages of Buy-Sell Agreements
While a buy-sell agreement can protect your business, it does have some potential downsides, including:
#1: Prevents Owners from Selling Whenever they Like
This restriction is perhaps the biggest disadvantage of the agreement. However, the point of the contract is to adequately protect all business owners.
#2: The Purchase Price Could Become Unrealistic
Disagreements can arise if the fair market value of the business is much different than the agreed-upon purchase price in the contract. This imbalance can be avoided by having the agreement regularly reassessed. Alternatively, your agreement can include specific language that protects owners from such disparities.
Bottom Line: Don’t Discount the Importance of Succession Planning
A buy-sell agreement can be an essential part of succession planning for businesses that have multiple owners. Unfortunately, only 34% of small businesses have any type of succession plan in place, according to a 2021 survey by PriceWaterhouseCoopers. If you don’t have a formal succession plan for your business, consider making it one of your 2022 business goals.
Oak Capital Advisors specializes in the unique financial planning needs of business owners. If we can help you take the next steps to secure your business and financial future, please schedule a call.