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What Is a Buy and Sell Agreement?
A buy-sell agreement is a legally binding contract that outlines how a partner’s ownership share in a business will be transferred if they die or leave the company. It ensures business continuity by defining who can purchase the departing partner’s interest and at what value, often using life insurance to fund buyouts and prevent disputes.
Common types include cross-purchase and redemption agreements, each offering different ownership and tax benefits. These agreements help safeguard the company’s stability and will be explored further throughout the article.
Key Takeaways
- A buy-sell agreement is a legally binding contract that outlines how a partner’s share in a business will be handled if they die or leave the business.
- These agreements often use life insurance policies to fund the purchase of a deceased partner’s shares, ensuring smooth business continuity.
- The most common types of buy-sell agreements are cross-purchase and entity-purchase (redemption) agreements.
- Cross-purchase agreements allow remaining owners to buy the interest of a departing partner, while redemption agreements have the business entity buy the interest.
- Buy-sell agreements prevent outsider ownership and provide a method for determining the value of a partner’s share.
Understanding the Mechanics of Buy-Sell Agreements
Buy and sell agreements are commonly used by partnerships and closed corporations in an attempt to smooth transitions in ownership when a partner dies, retires, or decides to exit the business. They prevent outsiders from gaining control of part of the business and provide a way to determine the value of each owner’s interest.
A buy and sell agreement requires that the business share of a departing or deceased partner be sold to the company or the remaining members of the business according to a predetermined formula. Surviving partners often use life insurance, bought by each partner on the others, to fund share purchases. The company may cover these as a business expense, with partners as beneficiaries.
Upon the death of a partner, the life insurance death benefit will be paid out to the remaining partners, who will use the funds to purchase the deceased’s shares from their estate, ensuring continuity of the business and its ownership structure. Having a buy-sell agreement avoids costly battles for control with surviving spouses or children and the use of probate court.
Limited liability companies, corporations, or sole proprietorships might use buy-sell agreements to name an employee as the business successor.
Important
When a sole proprietor dies, a key employee may be designated as the buyer or successor.
Exploring Different Types of Buy-Sell Agreements
There are two common forms of buy-sell agreements:
- In a cross-purchase agreement, the remaining owners or partners purchase the share of the business that is for sale.
- In an entity-purchase agreement (also known as a redemption agreement), the business entity itself buys the deceased’s share of the business.
Some partners opt for a mix of the two, with some portions available for purchase by individual partners and the remainder bought by the partnership.
A wait-and-see agreement combines elements from each of these two, where neither the partners nor the entity is explicitly named. At the time when it becomes necessary, the agreement will become either one or the other depending on what’s best for business continuity.
Tip
Partners should work with both an attorney and a certified public accountant when crafting a buy and sell agreement, along with a life insurance professional.
Essential Components of a Buy-Sell Agreement
Buy-sell agreements can vary depending on the business owners’ needs and the state’s statute for buy-sell agreements. Generally, they should include the following information:
- A list of the partners or owners involved and their current equity stakes
- A recent business valuation, which is used to place a value on each partner’s interest
- Events that trigger a buyout, such as death, disability, bankruptcy, or retirement
- A breakdown of who buys and acquires what
- How the buyout would be funded—for example, via insurance policies
- Tax and estate planning considerations for the individual partners and surviving beneficiaries
Benefits of Implementing a Buy-Sell Agreement
Buy and sell agreements are designed to help partners manage potentially difficult situations in ways that protect the business and their own personal and family interests.
An agreement can restrict owners from selling their interests to outside investors without approval from the remaining owners, for example. Similar protection can be provided in the event of a partner’s death. A typical agreement might stipulate that a deceased partner’s interest be sold back to the business or remaining owners. This prevents the estate from selling the interest to an outsider.
In addition to controlling ownership of the business, buy and sell agreements spell out the means to be used in assessing the value of a partner’s share. This can have uses outside the question of buying and selling shares. For example, if there is a dispute among owners about the value of the company or of a partner’s interest, the valuation methods included in the buy and sell agreement would be used.
Buy-Sell Agreement Templates
There are several online resources that offer low-cost or free templates for drawing up a buy-sell agreement. which can be especially useful for new or small companies. As your business grows or if it has a large number of partners from the onset, it is better to have a lawyer draft the document.
How Do You Establish a Buy and Sell Agreement?
A buy-sell agreement is a contract that sets out how the remaining partners or owners of a firm will obtain the shares of a partner who dies or departs from the business. This is usually done with the aid of a knowledgeable attorney.
In order to ensure that funds are available, partners in business commonly purchase life insurance policies on the other partners. In the event of a death, the proceeds from one of these policies will be used toward the purchase of the deceased’s business interest. This part of the agreement should be done through a life insurance agent with experience in this type of agreement.
What Are the Disadvantages of a Buy-Sell Agreement?
The drawbacks can include making it harder for business owners to sell their interests to anyone not mentioned in the agreement. At the time when the agreement was drawn up, that may have been desired. However, relationships and needs can change. The purchase price might also become dated. It may value the stake too high or low for the current business environment. Cost is another factor to consider. Getting one of these agreements drawn up by a lawyer can be expensive.
What Is the Benefit of a Buy and Sell Agreement?
A buy and sell agreement assures a smooth transition of ownership and business continuity in the event of the departure of a partner or large equity owner. The agreement is a legally binding contract that establishes how the departing owners’ shares will be obtained by the remaining partners. Without such an agreement, there can be legal battles and contestation. For instance, if a partner dies without an agreement, their shares may be passed automatically to their spouse, who may decide to keep them. Or, the spouse may want to sell them, but the remaining partners may not have the funds available to buy the shares.
The Bottom Line
A buy-sell agreement safeguards business continuity by defining how a departing or deceased partner’s shares are valued and transferred. Cross-purchase and entity-purchase structures outline whether partners or the business buys the shares, often funded through life insurance to ease financial strain.
While these agreements prevent disputes, they can be complex and costly, making professional legal and financial advice essential.
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