For many businesses, it is essential to have a buy-sell agreement in place from the outset of operations. In this article, we explain what a buy-sell agreement is, why you might need one, and best practices for valuing your business and creating a buy-sell agreement.
A buy-sell agreement is an important part of properly establishing your business entity and can limit liability in your business structure. The buy-sell agreement prevents an owner from selling their interests to an outsider without the consent of the other owners. It also provides an orderly and equitable method of determining the value of each owner's interest in the business.
Buy-sell agreements are typically used by businesses structured as partnerships and closed corporations. Essentially, they ensure a smooth transition of ownership should a partner retire, die, or exit the business.
State statutes governing the statutory close corporation may also mandate owners to enter into a buy-sell agreement. A buy-sell agreement may even be used by a limited liability company (LLC), conventional corporation, or sole proprietorship (where it is used to designate an employee as a purchaser of the business or business successor).
It’s important that you understand your state’s statute for buy-sell agreements. Ownership certificates (such as the share certificate of a corporation) must include a legend with the restriction on transfer created by the buy-sell agreement. In many cases, state statutes stipulate precise language be used in ownership certificates.
If you want to transfer your business interest, a buy-sell agreement can be the most efficient way to do so. A buy-sell agreement ensures:
A buy-sell agreement usually takes one of three forms:
If you operate an LLC, then a buy-sell agreement may be a provision within your operating agreement. However, it could also be a separate agreement if preferred.
For an example of buy-sell provisions for a member's resignation, death, or other transfer of an interest, refer to this sample operating agreement for a Delaware LLC.
Note: The sample operating agreement is for illustration purposes only. An operating agreement should be professionally drafted and tailored to the needs of the owners and the business' operations.
To avoid disagreements, a buy-sell agreement describes how an interest will be sold but also for how much.
Elements of a buy-sell agreement include:
The buy-sell agreement should clearly specify the method for valuing your business interests. The problem is most people have a hard time agreeing on that price. What is valuable to one person may have little value to another. In addition, your business is comprised of any number of variables, each possessing its own values. As with any major purchase, a deal must be negotiated to reach the final price.
To simplify the buy-sell process and ensure fairness for all owners, your buy-sell agreement should specify how your owners' interests are to be valued. Common valuation methods include
A buy-sell agreement can be as flexible as you and any other owners wish it to be. Different methods of valuation can be applied over the life cycle of the business. For instance, the agreement can initially provide use the formula approach. During the first year, a new business is unlikely to generate significant goodwill or appreciation of its assets and relationships among the owners could be especially unstable.
Thus, the agreement can specify, during a one-year period after the buy-sell agreement is signed, that fair market value is presumed to be equal to book value. This eliminates the expense of an appraisal, which would likely yield a result that approximated book value.
The buy-sell agreement also can apply different methods to fix the purchase price based upon the circumstances triggering the sale. For example, if the owner files bankruptcy action, the agreement might fix a lower amount (e.g., book value) as the price but a higher value (e.g., book value plus a percentage, or appraised fair market value) in other circumstances.
This strategy is open to challenge, so advanced strategies, such as this one, should only be employed with the advice of an attorney.
To be successful, our business’ owners should arrange for funding to ensure they can “buy-out” the person who has exited the business.
Popular funding methods include:
Deciding on a funding method typically depends on your business structure, ownership percentage, tax bracket, and the age of the owners.
One of the most popular methods to fund a buy-out is life insurance. Obviously, life insurance can only be used to fund a purchase in the event of an owner's death.
Disability insurance is another option. For example, the operating agreement might allow withdrawal by an owner who suffers a permanent disability (e.g. a disability that prevents the owner from working in the business for six consecutive months). Disability insurance might be used, in the same way life insurance is used, to facilitate the purchase of the interest. Note: The operating agreement may provide that an owner may not withdraw, except upon unanimous consent or subject to other enumerated conditions.
Furthermore, your buy-sell agreement might state that in specific situations, like when someone chooses to leave, the value of their interest is assessed as a lower amount. Additionally, the agreement could specify that the interest is bought gradually, over a set period, such as five or ten years. These choices can make it easier to buy the interest.
Because business affairs constantly change, your buy-sell agreement should be periodically reviewed to ensure it reflects your current circumstances and any future plans.
Most importantly, revisit your agreement’s valuation provision to ensure that it reflects the current value of your business.
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