Going into business with a partner or partners is a lot like entering a marriage: there will be good times and bad. Every business partnership should have a buy-sell agreement in place as part of a clearly defined succession plan. It’s like a pre-nuptial, but for a company.
A buy-sell agreement is an arrangement between business partners regarding what will happen if a partner leaves the company, either voluntarily, such as retirement, or involuntarily, such as a disability or death. Additional circumstances that might trigger a buy-sell agreement include personal bankruptcy, divorce, and disagreement. The buy-sell agreement would clearly dictate the circumstances surrounding potential ownership transition if or when the occasion arises.
A buy-sell agreement should be created early – well before it is needed and when owners can amicably, rationally, and strategically consider various scenarios and establish how the process will work under those conditions. It should be created in the best of times to address what may happen in the worst of times. Below are some consideration for business owners.
Death: In the event of an owner’s death, a buy-sell agreement would prohibit the deceased owner’s family from selling the shares to an outside party. It can also help the remaining owners avoid being in business with a deceased partner’s spouse or children who could otherwise inherit the shares. Life insurance policies are often used in buy-sell agreements so there is cash available to purchase the deceased owner’s shares. A well-structured agreement will have a detailed, pre-determined pricing mechanism set forth which removes the burden of negotiating a purchase price with any heirs.
Retirement: Many buy/sell agreements only address the death of an owner, but there are many other scenarios to consider, such as when a partner wants to retire or exit the business. In this situation, the agreement will outline the terms under which the remaining partner(s) or the business would purchase shares from the exiting partner.
Disability: If an owner becomes disabled, a buy-sell agreement could facilitate a buyout option for the business or the remaining owners. The agreement would specify how disability is defined which could be a long-term illness or injury or a mental illness that prevents a partner from working. It may be structured to include provisions for the injured or sick owner to continue receiving income.
Divorce: In a divorce settlement, an owner’s former spouse may be awarded a portion of the company. A buy-sell agreement will often allow the divorcing owner to have the first option to purchase his or her interest back from his or her soon-to-be ex-spouse. If the divorcing owner chooses not to exercise this right, then the agreement will often provide the remaining owners with the option to buy the interest from the divorcing owner’s spouse. The agreement avoids the risk of (a) having to manage the business alongside a co-owner’s ex-spouse or (b) losing control of the company altogether.
Disagreement: Businesses sometimes dissolve when owners can’t agree on company matters. Buy-sell agreements can outline what will happen if the owners cannot continue their partnership. It is much simpler and less expensive to agree on the terms ahead of time than to face protracted legal battles which could be detrimental to the ongoing operations of the business.
An effective buy-sell agreement should anticipate the intent and the needs of the owners. It should describe when and how to dispose of an owner’s interest, the sales price and how the price is determined, who the remaining owners are willing to accept as a substitute owner, and how a business sale will be funded, such as through cash or insurance proceeds. These considerations protect the partners and the business. It is recommended that business owners consult with a CPA, attorney, and a financial advisor on a buy-sell agreement and then reevaluate the terms every three to five years.