Does Your Business Need a Buy-Sell Agreement?

When you're mired deep in the day-to-day challenges of the management of your business, it's often hard to step out of the trees and take a good hard look at the forest. But at various points in the business cycle, it's important to do just that. For example, one of the key decisions you'll need to consider is what would happen to your business if you decide to step away, or you die or become permanently disabled. A buy-sell agreement can be a useful tool in helping you plan for these circumstances.

What is a buy-sell agreement?

A buy-sell agreement is a legally binding agreement that establishes when, to whom, and at what price you can sell your interest in a business. Buy-sell agreements are also known as business continuation agreements and buyout agreements.

You can create a buy-sell as a separate agreement or you can include certain provisions addressing the buy-sell issues in a business's operating agreement. Regardless, the agreement or provisions must clearly identify the potential buyer, any restrictions and limitations, and the conditions under which a sale will occur. Under the terms of the agreement, you and the buyer enter into a contract for the transfer of your business interest by you (or your estate) at the time of a specified triggering event. Typical triggering events include death, long-term disability, retirement, divorce, personal insolvency or bankruptcy, criminal conviction, loss of professional license, and resignation or termination of employment.

A well-crafted buy-sell agreement creates a market for your business interest, helps avoid becoming a shareholder with the deceased shareholder’s spouse, establishes its price (or a method for establishing its price), and provides funding mechanism to complete the business purchase. The ability to fix the purchase price as the taxable value of your business makes a buy-sell agreement especially useful in estate planning. That's because if death is the triggering event, it can help reduce the estate tax burden on your heirs. Additionally, because funding for a buy-sell agreement should be arranged when the agreement is executed, you're able to ensure that funds will be available when needed, providing your estate with liquidity that may be needed for expenses and taxes.

Pricing the company and funding a buy-sell agreement

A buy-sell should establish a formula for determining the purchase price or state the price outright. Without establishing this price in advance, lengthy disputes and lawsuits can arise at the time the ownership interest must be bought back. When the buy-sell involves family members, it must also be proven that the transaction is comparable to an arms-length sale between unrelated people and was entered into for a bona fide business purpose.

After determining the value of the business, you, your advisors, and other parties to the agreement will determine the best way to fund the transaction and the triggers appropriate for your business situation. There are many different ways to fund a buy-sell agreement, including a sinking fund, cash, borrowed funds, installment sale, self-canceling installment note, private annuity, life insurance, and disability insurance. Depending on the situation, one or more of the possible methods may be used.

Types of structures

Buy-sell agreements can be structured to meet the needs of both the business and its owner(s), taking into consideration tax consequences and individual goals. Following are three types of buy-sell agreements, along with brief descriptions of each:

An entity purchase (or redemption) buy-sell obligates the business to buy the interests of the departing owner(s).
With a cross-purchase buy-sell, each owner agrees to buy a share of the departing owner's interest. The business is not a party to the transaction.
A wait-and-see buy-sell is used when the parties are unsure whether the business or the owners will buy the business interest. Typically, the business is given the first option, and if it is not exercised, the remaining owners are given the opportunity. If the remaining owners do not wish to buy, the business must purchase the interest.

Other considerations

Dynamic document. Similar to your estate plan or overall retirement plan, your buy-sell agreement should not be a static document. The buy-out terms and the funding may need to be changed as the business and your personal situation evolves. For example, if a formula valuation is put in the document and yet your business grows threefold since the time of execution, your need for a great amount of life insurance may warranted. However, it has been my experience that business owners rarely circle back to make these types of adjustments.

Tied to overall financial plan. Integration of the business needs with your personal situation is critical for success in providing for a sound retirement and minimizing hiccups when passing your wealth to future generations. At Oasis Wealth, we have seen situations where insurance is bought with the goal for funding the buy sell agreement, but the wrong owner or beneficiary is named on the insurance policy. Or, the funding mechanism may be an installment note, but the period of the installment note is too short to allow the buying shareholder to keep the business afloat while buying out the business. Retaining a firm that provides a comprehensive review of the business and financial situation is important.

If you think that a buy-sell agreement might benefit you and your business, consult an adviser that takes time to understand your business and your personal financial situation. After all, your business is a critical component of your wealth and overall retirement plan– you do not seemingly small mistakes become huge problems for your family and you.