What is a Buy/Sell Agreement?
They’re called buy sell agreements, buyout agreements, or even business prenup’s, but whatever you call them, every business needs to have an exit strategy in place in the event an owner leaves the business. When no plan is in place, the departure of a key figure can lead to uncertainty and political infighting – or even litigation – between owners. A buy/sell agreement stabilizes what might otherwise be a turbulent transition by allowing the remaining owners to maintain managerial control, while also facilitating liquidity of ownership interests. But to provide these benefits, the agreement needs to be in place in advance, during the life of the business. However, according to Forbes, three out of four businesses do not have a plan in place. Going further it is my experience that most buy/sell agreements which exist plain do not work.
A well-drafted buy/sell agreement sets forth a roadmap to follow in the event an owner dies, becomes disabled and unable to work, is divorced, or elects to leave the business – whether due to retirement or conflict with other owners. Depending upon the needs and nature of the business, the agreement defines who is permitted or required to purchase a departing owner’s interest, how that interest will be valued, and which occurrences trigger the buy-out.
Death and divorce in particular can seriously destabilize the management structure of an unprepared business. When an owner dies, his or her heirs inherit the deceased owner’s shares or other ownership interest in the business. Similarly, a divorce decree may transfer some or all shares to an ex-spouse, who might have hard feelings toward the business or not care about it at all. A buy/sell agreement can prevent heirs or former spouses from taking managerial control by stipulating that, upon either event, the owner’s interest must be purchased by other owners or the business itself. In many cases, a business will maintain life insurance policies on its owners to ensure that adequate cash is available in the event a sale is triggered.
Buy/sell agreements can also address an owner’s voluntary withdrawl. Hopefully, it will be due to retirement, but a departure may arise from irreconcilable conflict between owners. In either situation, the departing owner wants to receive fair compensation, and the remaining owners want some say in what happens to the departing owner’s interest in the business. A good buy/sell agreement can address both concerns by requiring either the remaining owners or the business itself to purchase the departing owner’s interest at retirement, or if an unsolvable dispute arises.
If a buy/sell agreement is triggered and requires a buy-out of the departing partner’s interest, the next complication is reaching a consensus as to a fair purchase price. Fortunately, a professionally drafted buy/sell agreement can resolve that question as well by defining an agreed method for equitable appraisal of ownership interests, thereby avoiding potentially costly litigation. Depending upon the nature and complexity of the business, the agreement can either adopt an appraisal formula based upon revenue and assets or require hiring of a business valuation expert. Either way, it’s always preferable to agree on a fair system in advance rather than arguing over share value while emotions are running high or, even worse, fighting about it in court. I recommend that every business perform an annual evaluation or at least an evaluation every two years and that all buy out payments be based on this evaluation.
Buy/Sell agreements protect businesses and their owners by keeping managerial control with the people who know and care about the business, and by ensuring that departing owners (or their estates) receive fair compensation. Wise business owners will hire an experienced business attorney to draft a buy/sell agreement early in the game – nipping in the bud potential future conflicts and litigation and saving the business money and annoyance in the long run.