When starting a new business, there are a million things to do. Besides the pressing issues like registration, billing, or getting the first few customers, there are also a handful of important but non-urgent items you need to check off. One of which is whether you need to establish a buy-sell agreement with your business partners. Buy-sell agreements are foundational documents to protect not only your business but your family as well.
What Is a Buy-Sell Agreement?
Simply put, a buy-sell agreement is like a will but for a business. When business partners start a business, they arguably take on more risk than if they started a business alone. Instead of just managing personal and business risks, partnerships and multi-owner businesses must also account for personal risks related to each partner. For example, if one partner in a partnership tragically died, what would happen to the business?
In one scenario, the surviving spouse would inherit and likely sell their share of the company. If the remaining partners could not afford to buy out the spouse and the spouse sold it to an external party, what would that mean to the business? There is a substantial risk that within a few months, your partnership could replace your longstanding business partner with an outsider who has equal decision-making power.
A buy-sell agreement sets pre-determined rules for the business during traumatic events like the death of a partner. Continuity planning for the death of a partner is one of the most common examples, but you could design the agreement to include other triggering events like disability, divorce, or a partner leaving the firm. There are two main types of buy-sell agreements, a cross-purchase agreement and an entity-purchase agreement:
- Cross-purchase agreement: each partner funds the agreement and buys the deceased partner’s share of the company.
- Entity-purchase agreement: the company itself funds the agreement and buys the deceased partner’s share of the company.
Many times, buy-sell agreements are a combination of the two, sometimes referred to as hybrid agreements. It is possible to design an agreement where a surviving partner has the first option to buy out the deceased owner, and if declines then the company would buy it out. Ultimately, this is how to manage the risk of an outsider gaining equal access to your business. Either the partners themselves and/or the business would purchase the outstanding shares and keep the company working.
How It Works
The typical process contains three major parts: a legal component, a funding component, and a financial component. The first part is rather obvious, but perhaps most important. While the details in each agreement could vary, a good buy-sell agreement should include:
- An outline of triggering events that activate the buy-sell agreement.
- Expectations and processes to transfer ownership between parties.
- A valuation strategy to determine the purchase price of the business.
- An explicit funding mechanism to ensure the agreement can be executed.
Physically signing the buy-sell agreement should legally bind the company and partners to follow the ground rules. Working with your partners to establish this near the creation of your company can be much easier than when the agreement is actually needed.
The funding is the next critical piece. Without the funds to physically buy the ownership interest, the agreement is not helpful. The most common funding vehicle is using life insurance to cover the death of a partner. Using a cross-purchase agreement, for example, each partner would take a life insurance policy out on the other owners. That way each partner does not have to set aside any current assets and could run the premiums through the business to claim a business deduction. I should note that there are additional ways to fund the agreement, and those could vary in complexity based on the particular needs of a company.
The third part is focused on the financial and tax implications of the agreement. At times buy-sell agreements can touch on many different parts of your financial plan. Ensuring the legal and insurance protection to keep the business “in the family” is one thing, but verifying that it will not disrupt your tax, estate, retirement, and investment plans are important as well. Don’t forget that your partners are managing the risk of your passing as well, so a solid personal estate plan for your family is just as important. Make sure your attorney, insurance agent, tax preparer, and financial advisor help explain all the implications of the buy-sell agreement. When your financial team is not on the same page with your business and personal wealth, it is possible for things to go wrong.
Why It Is Important
Buy-sell agreements help manage risk in the business and keep expectations in line. The last thing you want to do is argue with your deceased partner’s spouse over the value of your company. Taking the time now to work out how the business can move forward without certain business owners is a crucial stage of maturity in a business. It allows everyone to understand expectations and allows each partner to create a personal estate plan around it. Setting up a buy-sell agreement is important, and it is important to make sure you do it correctly.
If agreements are not made correctly, it could mean avoidable mistakes that you have to deal with. Not having an agreement at all, or a templated one that doesn’t fit the needs of your business could mean thousands in legal fees, taxes, penalties, debt, and more. Make sure the buy-sell agreement spells out what method is used for valuing the company, what the funding requirements are, do the funding policies match the agreement, among other aspects. Similar to a family will it is important to review the buy-sell agreement every few years and make sure it is accurate. Not updating the agreement as the business evolves could lead to complicated tax and legal issues if the agreement is stale or outdated.
It is also important to verify that you appropriately fund the agreement. Business owners make the mistake of not initially funding the agreement or updating the policies or assets whenever the actual agreement is updated. It does no good to spend time and money to establish a buy-sell agreement, only to become useless if there is no means to fulfill it. Business owners could find themselves forced to find the funds to meet the agreement, which could mean selling part of the business and/or borrowing funds. It is important to protect the business and your family from risks that hopefully never happen but could have major implications if not thought out ahead of time.
Is It Worth It?
Buy-sell agreements are a foundational document in the life of a business. Creating a business continuity plan of sorts will help your company weather some of the hardest business challenges. The death, disability, separation, etc. of a business partner can have massive implications on your business. Don’t let a bad situation become worse. With the right agreement in place, you can better manage the risks that your business and your family face.
TC Falkner 