A Buy-Sell Agreement, or sometimes called a buyout agreement, is a legal contract entered into by partners in a business. This agreement specifies the triggering events that lead to a transfer of the business interest of a partner. The terms of the agreement vary for each business but generally contain a few items; a method for calculating business value, a description of the triggering event/s, how the business interest is transferred, and the timeline for the transfer.
Who should have a buy-sell agreement?
Any business that has more than one partner should have a buy-sell agreement. This agreement ensures that each partner and their beneficiaries are protected at the departure of one of the business partners. Without such an agreement in place, the likelihood of business failure after the departure of one of the partners increases significantly.
Any business that has more than one partner should have a buy-sell agreement.
When was the last time you reviewed your buy-sell agreement?
A. Within the last 12 months
B. It has been years
C. I have not looked at it since we set it up
D. I do not know if I have one
If you answered anything other than A, it is time to review your agreement to ensure it contains an
accurate picture of what you want to happen at the departure of one of the partners. Reach out to Blue Herring today to have us review your agreement.
What should be included in a buy-sell agreement?
1. Method for calculating business value
This is the most important item to have clarity on. Without an agreement on how much the departing
partners’ share is worth, disagreements in value often cost the opposing sides tens of thousands of
dollars in legal costs. Most often used and recommended is a multiple of revenue, profit, or EBITDA. A
calculation like this should significantly reduce potential future disagreements on how the value was
calculated. It is not recommended to use a fixed value due to the business values increasing or
decreasing on an almost annual basis.
2. Triggering events
This section will include the events that will trigger a buyout of the interest of one of the partners. Some common events contained in these agreements are death, disability, retirement, and the decision to step away. In addition to these, there are some less common triggering events like a shareholder vote to buyout a partner. The more specific these events are, the less potential gray area there will be for partners to disagree.
3. How the interest is transferred
This section outlines the transfer of money between parties to the buy-sell agreement. The two most
common structures are a cross-purchase and a redemption. A cross-purchase buyout strategy will allow the remaining partner/s of the business to purchase the shares of the departing partner. A redemption plan will have the business entity redeem the shares of the departing partner. The decision between these two plans is an important one as there are tax impacts to consider.
4. Timeline for transfer
While this section is generally self-explanatory, it should be given more thought and consideration than it gets. A major factor for this section is how quickly potential insurance claims payments (which are often funding parts of the buy-sell agreement) will provide capital to the business and/or surviving
partners. For example, Business XYZ has 2 equal partners and one of them becomes permanently
disabled which triggers a buyout. The Disability Buyout insurance claim is then approved but pays 12
months later (typical for buyout insurance).
Funding a buy-sell agreement
Completing the legal agreement is a great start for business partners but is only half of the work. The
other part is financially backing the buyout triggering events using insurance, specifically death and
disability. These insurance policies provide a lump sum of capital to the business or surviving partner/s to adequately buy out the departing owner. Without funding a buy-sell agreement with life and disability insurance, the surviving partner is left to figure out how to produce the capital needed to fund the contractual obligation in the agreement. More times than not this sudden need for capital is a difficult problem to solve without the tax-free inflow of insurances dollars.
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