An excellent way to safeguard a business is to create and execute a buy-sell agreement. A buy-sell agreement is a contractual document that outlines what happens if a business owner needs to transfer his or her interest in the company. A comprehensive buy-sell agreement will cover when a business owner can no longer be involved in the business for any reason, including death, divorce, bankruptcy or retirement. A buy-sell agreement can also protect the business from loss of revenue and cover the expense of finding and training a replacement. A buy-sell agreement can be put into place at any time, but it often makes sense to do so when a business is formed or when a new partner is brought in.
KEY FEATURES OF A BUY-SELL AGREEMENT
Buy-sell agreements outline how the remaining partners of a business will purchase the shares of another owner who dies or simply wants to sell. Typically, business owners would need to have a large amount of cash on hand to make this purchase, which is often unrealistic. As a result, many businesses fund their buy-sell agreement through insurance, especially in the case of a death.
As mentioned above, buy-sell agreements can be funded through insurance. Another insurance policy that small businesses might want to investigate is “key person” insurance. This policy insures against a potential loss of revenue that could result if one of the partners dies due to unforeseen circumstances. The insurance payout can help the business train and hire a new person to take the partners place.
The buy-sell agreement clearly lays out a succession plan for departing members, reducing the chance of misunderstandings or infighting that might result. A succession plan might include transferring an owner's assets directly to a family member or having it go through a living trust.
Outline Triggering Events
There can be any number of events that trigger the implementation of the buy-sell agreement. Some of the more common triggers include:
Disability: If an owner has become disabled or can no longer perform his or her duties, they may need to be bought out to preserve the integrity of the business.
Divorce: In the case that one of the owners gets a divorce, it might be within the organization’s best interest to simply buy the owner out. This prevents the business from being used as collateral or an asset during the divorce proceedings.
Debt: In a substantial number of situations, small business owners are the personal guarantors for business loans or debt. If the owner defaults on a loan, even a personal one, it can compromise the business. In a partnership, since one's ownership stake in the company could be liquidated to pay off bad debts, it would be prudent to include a clause that deals with this possibility.
Conflict: If a dispute cannot be settled between the owners, the subsequent tension and non-communication can severely limit the business’ performance. How a buyout should proceed in the case of such a dispute should be included in the agreement.
Retirement: In the case of retirement, the departing owner can still receive a payout for the shares he or she owns, but the remaining owners should also be able to reclaim that owner’s interest in the company.
Death: In the case of an owner’s death, the buy-sell agreement—as well as individual life insurance policies—will cover the large buyout that will be due to the surviving family members as the death benefit.
TYPES OF BUY-SELL AGREEMENTS
There are two main types of buy-sell agreements commonly utilized by businesses:
Cross-Purchase Agreement. In a cross-purchase agreement, key employees have the opportunity to buy the ownership interest of a deceased or disabled key employee. Each key employee typically takes out an insurance policy on each of the other key employees. Cross-purchase agreements tend to be used in smaller companies where there are not too many key employees to insure.
Stock-Redemption Agreement. Stock-redemption agreements are formal agreements between each of the key employees—and the business itself—under which the business agrees to purchase the stock of deceased, retired or disabled key employees. Key employees agree to sell their shares to the company, often in exchange for a cash value.
Both of these types of buy-sell agreements establish a market value for a key employee’s share of the company.
FUNDING A BUY-SELL AGREEMENT
There are several options for funding a buy-sell agreement:
Set Aside Funds. Money for a buy-sell agreement can be set aside, as long as it is easily accessible. These funds must be kept up for the life of the company, and may present a temptation during fiscally tough times. The business owners must determine the appropriate amount needed to cover the cost of a buy-out.
Borrow the Needed Amount. A company can borrow enough to buy out a withdrawing key employee at the time of his or her death or upon another triggering event. However, the loss of the employee can often affect a company’s ability to secure a loan, and the payments become an added stress on the business during an already difficult time.
Life Insurance. Purchasing a life and/or disability policy in order to fund a buy-sell agreement is an option when preparing for the future. Using life insurance enables a buy-sell agreement to be funded with premium payments and attempts to ensure that funds will be available when they are needed.
UPDATING BUY-SELL AGREEMENTS
It is best to keep the buy-sell agreement up-to-date by revising it every three to five years. In that time, growth or devaluation of the company could result in the parameters needing to be changed. It is especially important for organizations that experience rapid growth to revise their buy-sell agreement, as business owners do not want to be bound by an outdated agreement that neglects to reflect changes in the state of the company.