One of the most overlooked necessities of owning a business – or even part of a business – is having something called a business buy-sell agreement.
Part of the problem is that the term is a little misleading. Contrary to common perception, it’s not an actual agreement to buy or sell a business. Think of it as a “what-if” agreement that spells out what would happen if, for example, an owner or partner gets divorced, goes bankrupt, retires, is disabled or dies.
If your closely-held or family business has more than one owner and you don’t have such an agreement, the business could face difficult financial or tax problems if something changes. And this applies to nearly any type of legal business entity, including LLCs, sole proprietorships, partnerships and corporations.
A business buy-sell agreement – sometimes called a buyout or partner buyout agreement – is an agreement between partners or co-owners governing these basic things:
1. When – and under what conditions – a partner or co-owner can sell his or her interest in the business.
2. Who will be allowed to buy into the business?
3. Circumstances that would require a co-owner to sell.
4. How the price of an owner’s interest will be determined.
It’s a little like a pre-nuptial agreement for business owners. There are too many uncertainties to leave this to chance, including misconduct and just plain disinterest in the business that can happen over time.
But while the causes are many, the results are predictable. Without this agreement, an owner’s exit can be rancorous and disruptive, perhaps at a time when the business can least afford those kinds of headaches.
There are lots of what-if variations:
• What if a partner gets divorced and her ex-husband —who gained part ownership in the settlement — causes trouble?
• What if a co-owner demands to be bought out at an unreasonable price?
• What if an owner develops a substance abuse problem goes bankrupt and your new co-owner is one of his creditors?
You get the idea. The process of working out a buy-sell agreement can even strengthen a business from the outset, as partners better understand the possibilities, and each other. And the cost is minimal compared to the benefits.
Be sure to think about funding. Just because an agreement calls for a partner buyout doesn’t mean the money will be available. “Key person” life and disability insurance can help. Or the agreement might allow installments over a period of years.
Your agreement should include a right of first refusal that prevents departing partners from selling without first offering their interest to remaining owners. This is one way to control who is allowed to own an interest in the company. It will prevent unwanted outsiders from buying in, and allows the business to buy a deceased owner’s interest rather than allow inheritors to move in.
The topic of ownership vs. employment is also touchy. For example, what if an active partner wants to stop working day-to-day in the business, but still wants to remain an owner? Is this allowed? Your buy-sell agreement can address this issue.
While setting a price on the shares can be exceedingly difficult, you can certainly include a formula for setting the price as part of the agreement.
There are three basic buyout agreement types:
- In a “cross-purchase” agreement, a departing owner sells directly to remaining owners. This works best for partnerships, LLCs or S-corporations with no more than a half-dozen or so owners.
- In “Stock redemption” or “entity-purchase” agreements, the business itself buys back the departing owner’s interest and retires the shares.
- “Hybrid” agreements combine elements of both.
Once you have an agreement in place, review it regularly. Circumstances will undoubtedly change, and your agreement must change too. Pay special attention to the valuation formula. Have the business appraised every few years as a crosscheck.
These resources can help:
- RocketLawyer.com offers sample buy-sell agreements and information about how to customize your own. Visit the site and search for buy-sell agreements.
- You will find a helpful FAQ on buy-sell agreements in the small business section at FindLaw.com.
- Buy-SellAgreements.com sells a fully customizable buy-sell agreement template that you can download for $30.
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