Ask Our Experts A Question .
Entrepreneurship
What is a Buy-Sell Agreement?
2023-03-29
If you own a business, it’s important to consider everything that could happen in the long term. One of the most important considerations here is what would happen to your business shares if you ever leave the company. This is what a buy-sell agreement is all about.
Without these agreements in place, business partnerships could become very complicated in the event of a partner leaving the business in any way. Having the right contracts in place avoids these issues and provides clarity on how the business will move forward.
This quick guide will explain exactly what you need to know about buy-sell agreements, how they work, and what they include.
What is a Buy-Sell Agreement?
A buy-sell agreement, a buy-and-sell agreement or a buyout agreement, is a type of contract that outlines what will happen to a partner’s share of the business if the partner leaves the business or dies. These agreements are legally binding contracts that are important to establish whenever you set up a business partnership.
In most cases, a buy-sell agreement will say that the partner’s share of the business could be sold to any remaining partners in the business. In many cases, life insurance policies are used alongside buy-sell agreements to fund business buyouts in the event of the business partner's death.
How Does a Buy-Sell Agreement Work?
Buy-sell agreements are established at the start of any business relationship between two or more partners. These agreements can be used in sole proprietorships, partnerships, and closed corporations. If a partner chooses to leave the business, retire, or if they are forced to leave the business or die, then reassigning their shares will become a much easier process.
These agreements set out a formula that dictates how the partner's shares will be valued and sold. These shares will either be sold to the company or the other partners of the business.
Using a buy-sell agreement makes the transition period a lot more transparent when a business partner leaves. Because these contracts are legally binding, the other business partners have no other options for what will happen to the leaving partner’s shares. If a buy-sell agreement is not established, all kinds of complications, disputes, or legal battles could erupt from the situation.
Types of Buy-Sell Agreements
There are two main types of buy-sell agreements. These are:
- Cross-purchase agreements: This is when the other business partners who remain purchase the leaving partner’s shares
- Entity-purchase agreements: The company entity purchases the shares of the departing partner
It’s also possible to have buy-sell agreements that combine both of these different types of contracts. In this case, part of the leaving partner's shares is put up for sale to the other partners, while the rest of their shares are sold back to the company.
With sole proprietors, it's possible to have a buy-sell agreement where a key employee is designated as the buyer of the business owner’s shares if they depart.
What to Include in a Buy-Sell Agreement
It’s important to include as much relevant information in your buy-sell agreement as possible. This will help the agreement cover all possible scenarios.
Here is the general information that a buy-sell agreement needs to cover:
- Partners: The agreement should list all of the partners in the business and how much equity stake each partner holds
- Buyout events: List all possible events that could result in the buyout of a partner’s shares. This could include things like retirement, bankruptcy, death, disability, etc
- Valuation: An up-to-date valuation of the company’s equity
- Tax and estate planning: Include tax and estate planning considerations for all individual partners of the business
- Funding instrument: Funding instruments, like life insurance policies, are often used to fund business buyouts in the event of death
The goal of these agreements is to provide complete transparency in any situation where a partner’s shares become available. This includes a clear understanding of how much these shares are worth and where they will go.
Although it may not seem like a pressing issue when you start a business, you must consider the continuation of the business in the long run. This is especially important when there are multiple people involved in the business.
Buy-sell agreements help you plan for the future. They provide a clear framework in the event of a business partner leaving, which will help to keep the business operating without any issues. So if you’re starting a business or entering a partnership, definitely consider establishing one of these agreements from the beginning.