As a business owner, you’ve invested countless hours building your company. But have you considered what happens if you or another owner exits the business? Whether due to retirement, disability, death, or other personal circumstances, ownership transitions can create significant uncertainty. A buy-sell agreement is a crucial legal tool that provides a roadmap for these inevitable changes.
What Is a Buy-Sell Agreement?
A buy-sell agreement is an important part of properly establishing your business entity and can limit liability in your business structure. The agreement prevents an owner from selling their interests to an outsider without the consent of the other owners. It also provides an orderly and equitable method of determining the value of each owner’s interest in the business.
These legally binding agreements lay out what will happen to each owner’s share of the business upon a triggering event, enabling an orderly transfer of the business when needed.
When Does a Buy-Sell Agreement Take Effect?
Buy-sell agreements are typically structured to activate during specific transitions, commonly referred to as “triggering events.” Most commonly, these agreements are triggered when an owner:
- Dies or becomes significantly disabled
- Gets divorced
- Retires from the business
- Is forced to resign from employment with the business
Why Your Business Needs a Buy-Sell Agreement
Without a proper buy-sell agreement in place, your business could face serious challenges during ownership transitions:
A well-crafted buy-sell plan ensures that the remaining owner or owners have a blueprint and just as importantly, the legal authority to keep the business up and running. For family-owned businesses, a buy-sell plan provides a buyer for an owner’s shares and protects remaining owners from the sale of controlling ownership interest to an outside buyer.
If you hold an interest in a business that’s closely held or family owned, a buy-sell agreement should be a component of your estate plan. The agreement provides for the orderly disposition of each owner’s interest after a triggering event.
A buy-sell agreement ensures business continuity, proper compensation for survivors or designated successors, assurance that the deceased’s business share isn’t passed to someone unsuitable, and protection of assets if a triggering event occurs.
Types of Buy-Sell Agreements
Depending on your business structure and goals, there are several types of buy-sell agreements to consider:
A buy-sell agreement usually takes one of three forms:
- Cross-purchase agreement: A withdrawing owner agrees to sell their interest to the remaining owners. This is the simplest form and is suited to small businesses with only a few owners.
- Entity-purchase agreement: The withdrawing owner agrees to sell their interest to the entity, which then retires the ownership interest.
- Hybrid agreement: A combination of the first two. Typically, the withdrawing owner must first offer their ownership interest to the entity. If the entity declines or is unable to make the purchase, then the shares must be offered to the other owners.
Another approach is the “wait and see” model, the most flexible type of buy-sell plan that allows remaining business owners to decide, at the time of the triggering event, whether the business or the owners should purchase the interest. It generally gives the business the right of first refusal.
Each type has different tax and legal implications. For example, redemption agreements (where the company purchases the interest) may trigger a variety of unwelcome tax consequences, while cross-purchase agreements can be cumbersome, especially if there are many owners.
Valuation Methods: Determining the Purchase Price
One of the most challenging aspects of a buy-sell agreement is determining a fair value for the business interest. Common valuation methods include:
- Fixed price: This appears a simple method, but often the initial fixed price is not updated and may not reflect the value of the business when the triggering event occurs.
- Independent appraisal: Agreed on by the owners when the buy-out agreement is executed. Although a best practice, this method can be costly and potentially delay any settlement.
- Formula approach: This involves valuing financial statements, such as earnings or revenues, and determining a book value at a specific date.
Independent appraisals almost always produce the most accurate valuations. Formulas tend to become less reliable over time as circumstances change and may lead to over- or underpayments if earnings have fluctuated substantially since the valuation date.
Funding Your Buy-Sell Agreement
Having a buy-sell agreement is essential, but equally important is having the financial resources to execute it when needed. Popular funding methods include life or disability insurance, installment notes, cash, sinking funds, selling assets, or borrowing.
Without a buy-sell agreement, there may not be enough liquid cash available for the firm to buy out the departed owner, and remaining owners may not be able to come up with enough on their own — especially if the company’s valuation has risen substantially. That’s why buy-sell agreements typically include a funding mechanism such as a company-funded or a self-funded life insurance policy for each owner.
Keeping Your Buy-Sell Agreement Updated
A buy-sell agreement isn’t a “set it and forget it” document. Because business affairs constantly change, your buy-sell agreement should be periodically reviewed to ensure it reflects your current circumstances and any future plans. Most importantly, revisit your agreement’s valuation provision to ensure that it reflects the current value of your business.
If no triggering event appears likely anytime soon, consider reviewing your buy-sell agreement annually — perhaps even more often if the business is enjoying rapid expansion or revenue growth that could impact its valuation.
One pressing reason to review sooner rather than later is because, absent congressional action, the federal gift and estate tax exemption is scheduled to be halved beginning in 2026.
The Benefits Beyond Business Continuity
A buy-sell agreement can provide several significant benefits, including keeping ownership and control within your family, creating a market for otherwise unmarketable interests, and providing liquidity to pay estate tax and other expenses. In some cases, a buy-sell agreement can even establish the value of an ownership interest for estate tax purposes.
Next Steps: Creating Your Buy-Sell Agreement
Developing a comprehensive buy-sell agreement requires careful consideration of your business structure, ownership goals, and potential future scenarios. At HV Legal, our business attorneys specialize in creating customized buy-sell agreements that protect your interests and ensure business continuity through any transition.
Don’t wait until a crisis forces your hand. Contact us today at 440-578-7827 to schedule a consultation. Our team will work with you to develop a buy-sell agreement that safeguards the business you’ve worked so hard to build.
For more information about business succession planning, visit the Small Business Administration at https://www.sba.gov/business-guide/manage-your-business/plan-your-exit or the American Bar Association’s resources at https://www.americanbar.org/groups/business_law/resources/.
