Imagine this scenario: You and your partners have worked hard to start a business. You could be advancing steadily, closing deals, thriving, and then something unexpected happens. For example, one of your partners could decide that they want to leave the business. Now what?
This is just one of the situations in which buy sell agreements create a playbook for what happens next. These agreements are legally binding contracts that establish what will happen in the event of a partner’s exit from the business, whether it’s due to resignation, termination, disability, or death.
If your business has two or more owners, this is a vital agreement for streamlining the transfer of ownership.
Common contingencies
Buy sell agreements are essential for controlling the makeup of the ownership of a business, regardless of whether it’s a real estate wholesaling business, a real estate agency, or something that has nothing at all to do with real estate. They establish in writing what happens in the event of a partner’s resignation, termination, and death.
One of the more common contingencies is that none of the partners can sell their stake in the business without the other partners’ approval.
Because these agreements address what happens in the event of a partner’s death, it’s common for the partners in a business to take out life insurance policies on the other partners. Once a partner passes away, the proceeds from the life insurance policy can be used to buy out the beneficiaries of a partner who passed away.
The agreement can also maintain that the shares of the business will not be given to a former spouse in a divorce or to beneficiaries of the deceased. Additionally, they direct how the transfer of ownership amongst the partners will be handled.
These agreements include language specifying how a company’s value will be determined as well as the circumstances under which a company’s owner can be removed.
Drafting the agreement
A buy sell agreement is an important legal document, so it’s important to have an attorney draft or review the agreement. With that in mind, there are certain things that everyagreement needs to include.
First, you’ll need to include the names of the partners and their respective stakes in the business. The agreement should also establish the events that would trigger a buyout. Typically this includes death, disability, divorce, or a partner’s exit from the business for any reason.
Finally, it should always include a recent valuation of the business’s equity and specify how a partner’s buyout will be funded.
Funding a buyout
There are a lot of variables that can affect how a partner’s buyout is funded, such as the number of partners, the liquidity of a business’s assets, and the business’s tax bracket. Here are some common ways that buyouts are funded:
- Insurance policies
These are used for the death or disability of a partner. The proceeds of the insurance policy will be used to buy out a partner or his or her heirs.
- Installment notes
This structure allows the remaining partners to buy out the departing partner’s shares over time.
- Cash
If the business has cash reserves and the partner’s departure cannot be funded by insurance, this is a quick and simple approach.
- Sale of assets
When a company lacks liquidity, they may opt to sell off non-essential assets to fund the buyout.
- Asset leverage
Borrowing against certain company assets also helps fund a buyout when there is not enough cash on hand.
Valuation methods
As stated above, these agreements include details about how to value the shares of a departing owner. Here are the four most common methods for the valuation of a partner’s business shares:
- Fixed Price
This is a rare method of valuing a company. Ideally, a company’s value will increase over time, so the departing partner could be at a disadvantage if they agree to a fixed price.
- Independent Appraisal
Shareholders specify in the agreement that an independent appraisal will determine the value of the business.
- Market rate
The value of the partner’s stake in the company is calculated based on the value of similar, recently sold businesses.
- Formula
The partners establish a formula, typically based on the business’s assets or earnings, to establish its value.
Common mistakes with buy sell agreements
While it’s important to have a contractual agreement with your business partners, the existence of this document alone cannot protect the partners’ interests. The most common mistake that businesses make is that they create the contract, then leave it alone while the business changes and grows. The risk here is that the agreement may not reflect the current value of the business. This is why it’s so important to review the terms at least annually to ensure that it is still reflective of the status of your business.
Another common oversight is the failure to include real estate assets in the agreement. It’s common for larger businesses to create a separate entity to hold a business’s real estate. This is usually for tax and liability purposes. Unfortunately, failure to include real estate in the agreement can result in a departing partner not receiving their due when it’s time to sell. Any agreement that fails to include all of a business’s entities is incomplete.
The third most common mistake business owners make is that their buy sell agreement is underfunded. This can happen in a variety of ways. Sometimes, businesses won’t have the cash on hand or sufficient assets to implement a buyout. In cases where a partner dies, the terms of the insurance policy may not match those of the agreement. It’s important for partners to understand what their insurance policies will cover in the event of a partner’s death or disability.
Key Takeaways
Creating a buy sell agreement requires business partners to consider some common occurrences, such as a partner’s resignation, along with worst case scenarios. While it may be tempting to avoid creating this agreement because of the difficult conversations that can arise, failing to put an agreement in writing can jeopardize your business’s ability to remain in operation.
Business partners should also make a point of understanding what their insurance policies will and won’t cover, and how the insurance policy aligns with their agreement. Most importantly, a Buy Sell Agreement isn’t a “set it and forget it” document. A business can grow and change substantially over the years, so make sure that your agreement is current and reflective of its present-day operations.
