A buy-sell agreement is a legally binding contract between the co-owners of a company that goes over a variety of business-changing events, such as if an owner dies, decides to retire, or is forced to leave the business. A good analogy for a buy-sell agreement is a premarital agreement. Just like a prenup, a buy-sell is drafted as a game plan to help coordinate if, or when, an issue actually occurs.
In drafting a buy-sell agreement, the parties must decide what events will fall within the scope of the agreement and how each event will be handled. Two of the more common triggering events include the death or permanent disability of an owner. Even the most successful business will often lack the cash flow necessary to buy out an owner’s interest upon an unexpected death or disability.
In an effort to plan ahead, owners will often take out life and disability insurance policies on their co-owners. This way if an owner becomes disabled or passes away, the remaining owners will have the necessary funds to buy out their ownership interest. A good buy-sell agreement outlines how this will take place. In the absence of a buy-sell agreement, the deceased owner’s ownership interest will first pass to the estate and the remaining owners could face a long, complicated purchasing process.
Other important provisions in a buy-sell agreement include how each owner’s interest will be valued and the procedures in place if the owner decides to voluntarily sell. An ownership interest in an LLC or a corporation is considered personal property, which means that owners can freely transfer their ownership interest as long as there are no provisions in the company’s charter documents or imposed by law. Many small business owners go into business because they are excited to work with their co-owners. But that changes if one owner decides to sell. Having restrictions that force the departing owner to first offer his or her interest to the remaining owners provides a mechanism to ensure the ownership of the company stays in the hands of a select few.
In order for the agreement to achieve its basic objectives, the valuation and purchase price provisions should be clear and unambiguous. Often, the agreement is drafted at a time when the parties are both on friendly terms and in agreement for where the business is headed, which lessens the chances for a dispute when the provisions become applicable. An effective valuation mechanism should provide a means for determining the purchase price of a departing owner, whether the value is defined as an agreed upon amount by the owners, a formula, or through an agreed method using a third person.
As this brief article demonstrates, there are a number of factors to consider when outlining a buy-sell agreement. Here is a small list of talking points for your company’s attorney and CPA and your business partners.
- Sources of funding for purchased ownership interest.
- Will the ownership interest be redeemed by the company or will each owner purchase the departing owner’s interest.
- The owners who will be included in the buy-sell agreement.
- The tax bracket of each owner and the corporation.
- The desired tax basis for the remaining owners.
- Tax treatment for the departing owner and ensuring an unexpected dividend does not occur.
- Whether installment payments are considered and the impact interest has on the entity.
- Establishing a valuation procedure for each ownership interest to avoid ambiguity.
The type and scope of terms can vary depending on a number of factors, such as the size of the organization, the health of the owners, the financial condition of the company and the individual preferences of the parties. Before undertaking such a project, it’s highly advisable to speak with an attorney, a CPA and an insurance professional who can help you plan ahead. Taking the time now to think through how you’d like a situation to be handled if it unexpectedly occurs can pay huge dividends down the line.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.
Doug Bend is the founder of Bend Law Group, PC, a law firm focused on small businesses and startups. He is also the General Counsel for Modify Industries, Inc. and tIFc LLC and a Legal Mentor in The Hub Ventures Program. This article was co-authored by Doug Bend and Alex King. If you have any questions, give them a call at (415) 322-0762 or email at email@example.com.
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