What is Buy Sell Agreement?
Why do you need a buy sell contract?
What are the essential elements you should know!
In this article, I will break down the notion of Buy Sell Agreement so you know all there is to know about it!
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Table of Contents
What Is A Buy Sell Agreement
A buy sell agreement is a type of agreement between business partners or a company where they mutually define how to reassign the partner’s share in the business in the event of death or if they choose to leave the business.
In other words, using a buy sell contract, the partners determine in advance how and to who their shares or interest in the business will be transferred or sold should a partner decide to leave the company or die.
Purpose of Buy Sell Agreement
The main purpose for putting in place a corporate buy-sell agreement or for any other types of legal entity is to ensure that current business owners can buy the shares of a deceased or departing partner.
Generally, in most cases, the partners will stipulate that the exiting partner (or the deceased) will sell his or her shares to the other business partners or back to the company.
In addition to the overall agreement as to what will happen with the shares of the departing partner, it is common for the parties to also define the procedures that must be followed to buy back the shares.
Quite often, the business partners will also have terms and conditions relating to business valuation and how the shares are to be valued for the buy back.
Types of Buy Sell Agreements
What are the most common types of buy sell agreements?
When the existing business partners buy back the shares, we refer to that as a “cross purchase” and when the company buys back the shares we call that a “redemption”.
It’s possible that a buy sell agreement include terms and conditions relating to a cross purchase agreement and a redemption agreement to cover both scenarios.
You will see cross purchases and redemption agreements used in combination with the purchase of insurance policies.
For instance, in a cross purchase plan, you are likely to see a business owner buying a life insurance on each of the other owners allowing him or her to use the insurance payout to buy the deceased owners’ shares.
In an entity purchase or stock redemption plan, you are likely to see an agreement between the shareholders and the company where the business buys life insurance on the life of the shareholders so, in the event of death, the company can buyout the deceased shareholder’s shares.
A buy and sell agreement can relate to any type of business, such as:
- Real estate buy sell agreement
- Corporate buy sell agreement
- Partnership buy sell agreement
- Buy sell agreement LLC
Whenever there’s a business interest that is owned by a shareholder, partner, member, or any person and the business partners wish to determine in advance how to buy back the interest of a leaving or deceased partner, a sell buy agreement can be useful.
Buy Sell Agreement Definition
What is the definition of a buy sell agreement?
According to Investopedia, a buy sell agreement is defined as follows:
A buy and sell agreement is a legally binding contract that stipulates how a partner’s share of a business may be reassigned if that partner dies or otherwise leaves the business.
In other words, buy-sell agreements are:
- A legally binding contract
- Between business partners
- Agreeing to sale or transfer of business interest
- In the event a partner exits the business or dies
How Does A Buy Sell Agreement Work
A buy sell agreement is a “contract” or “agreement” between business partners or a company outlining how the business interest of a business partner will be assigned, transferred, or sold in the event a partner retires, dies, or chooses to leave the company.
Depending on the size and complexity of the business, a buy sell agreement can vary in complexity as well.
In the context of a small business with a few shareholders and a simple business, it is conceivable that the business partners may want to be clear about who can buy the shareholder or partner’s shares if they decide to split up or one cannot participate in the business.
In this agreement, the partiers will potentially agree on the following aspects:
- The notice that a partner must give
- How long the parties have to handle the transaction
- Buys sell agreement insurance in the event of death
- How to evaluate the shares or business interest or valuation formula
- Where will the close take place
In one scenario, the existing business partners can buy the shares of the exiting business partner (that’s generally called a cross purchase transaction).
In a second scenario, the corporation, LLC, partnership, or legal entity will buy the shares of the exiting shareholder, member, or partner (we generally call that a redemption agreement).
It is also possible to have a hybrid agreement where a portion of the departing partner’s shares will be made available to the existing shareholders to buy and another portion will be redeemed by the company.
Why Buy Sell Agreements Are Important
Buy sell agreements are important for business partners as it allows all partners to “separate” or “part ways” in an amicable and friendly manner.
When you start a new business with a partner, you are focused on how you will launch the business, how to target your clients, where to raise capital, and do all the fun and exciting things to launch a new business.
However, as part of that process, it’s also important to think about what could happen if the partners no longer want to remain a partner in the company, they want to leave, or potentially pass away.
If the partners do not enter into a business buy sell agreement when things are “good”, it may be detrimental and very costly if the partners decide to leave one another without a clear framework.
That’s when the partners may get into disagreements, disputes, and may need to involve lawyers etc.
That’s bad for business and it’s bad for the partners.
To prevent such conflicts, business partners can hedge their risk by entering into a “buy sell agreement” where they mutually decide on the terms and conditions applicable should they choose to leave the business.
A simple but solid agreement can help protect the business, each partner’s interests, and that of their families.
Buy Sell Agreement Terms
What are the terms that you’d expect to find in a “buy and sell” agreement?
Although every business situation is unique and it would not be right to say that a standard buy sell agreement can cater to all possible needs, we can generally find the following provisions in many agreements:
- Call rights
- Put rights
- Deadlock provisions
- Right of first refusal
- Business valuation formula or process
- Buy and sell insurance (life, disability, or other)
Call rights are provisions allowing the corporation to purchase a shareholder’s shares.
Either the shares can be bought at a premium or at fair market value.
The put rights are provisions allowing the business owner to demand that the other business owners or company acquire his or her shares.
A deadlock provision is a legal mechanism where in the event of a deadlock, the partners decide how to proceed or even dissolve the business.
The right of first refusal (or ROFR) allows a business partner to sell his or her shares to a third party provided that the shares are offered to the company or existing partners before being sold to a third party.
The business valuation provision or formula allows for the business partners to either define the value of their shares or defer to an independent third party to perform the valuation for them (such as a business appraiser, accountant, or another valuation expert).
The life insurance provision allows the business partners, particularly in small to medium-sized businesses, to mitigate the risk of an unexpected event such as disability, long-term illnesses, or even death.
In such instances, the partners can rely on their business insurance to access the funds necessary to buy a partner or at least fund a portion of the purchase.
How To Set Up A Buy-Sell Agreement
By putting a good buy-sell agreement in place, you may avoid lots of headaches, reduce potential causes of conflict, and have a business continuity plan in the event a partner chooses to leave or is no longer able to participate in the business.
The first thing you should do is to consider putting your buy sell agreement in place early on in your business, when things are going well.
It’s more likely that you will be able to come to a mutual agreement when things are going well or you are in the early stages of the business.
When something goes wrong or relationships get conflictual, you can rest assured that it may be unlikely or even impossible to agree on a mutually satisfactory agreement.
The second thing to consider is to have a clear “trigger” or “triggering event”.
Decide on what events can result in the trigger of the buy sell contract.
When you have the trigger, then you’ll need to be clear about the procedures to follow.
Particularly, you’ll want to define how to value the shares of the exiting partner (do you have a formula in your contract, will you need to mutually agree on a value, or go see a third party evaluator or accountant?).
Be clear as to who can buy back the shares.
Are the shares to be bought back by the company, will the remaining business partners buy the shares, or a combination of both?
Consider getting a buy sell agreement insurance, either life insurance, disability insurance, or any other type of insurance policy to protect you in the event of an unexpected event.
If you have the right insurance in place, you can have the peace of mind that if bad luck strikes (like an unfortunate event of death or disability), you will have the financial means and funds necessary to purchase the shares (or parts of it).
Aside from the trigger, procedures, buy back rights, and insurance, you can include other provisions that may be suitable for your business.
You may want to speak to a business lawyer, accountant, tax advisor, or business valuation expert for advice and strategic planning.
Buy Sell Agreement Insurance
What’s notable is that the sudden death of a business partner can put the small business at risk.
To avoid having to deal with a sudden loss of a major partner or not having the cash available to do a buy back of shares on short notice, it’s common for business partners to purchase buy sell insurance allowing them to mitigate the risk of sudden and unexpected death of a partner.
Buy sell agreements life insurance are offered by many insurance companies and it can truly be a life-saving decision for small businesses.
Imagine that Mary and John own a small business together in real estate.
The company is worth $4,000,000 and each of them own a 50% interest in the corporation.
Now, imagine that the company had just recently used up all its cash and marketable securities to purchase a new real estate property.
As such, the company is quite low in available cash reserves.
Unfortunately, and quite suddenly, John dies in a fatal car crash.
Mary looks at the company records and notices that they had entered into a buy sell agreement real estate requiring the company to buy out John’s shares.
In this example, the buy sell agreement life insurance taken in the event of John’s death will come and save the day as it will provide the necessary funds allowing the company to buy back John’s shares or at least part of it.
Buy Sell Agreement Examples
Let’s look at a couple of examples of buy sell agreements to see how they work and how a buy-sell agreement for small business can help mitigate risk.
In the first buy sell agreement example, imagine that a business partner dies and his or her shares are to go to the partner’s estate.
To prevent the deceased partner’s estate from entering into the business, the surviving partners can use the buy and sell contract to force the purchase of the estate’s shares by the company or remaining shareholders.
This is a much better outcome for the company than having the estate of a deceased partner, who probably has no experience or knowledge in the business, become a shareholder or part-owner of the business.
With a “buy sell” agreement, the surviving business partners can effectively exercise their rights to buy the shares of the deceased partner (and hopefully thave have a buy sell life insurance policy in place to access the funds needed) to prevent the estate from getting involved in the business.
In the second example, let’s look at a buy sell agreement corporation for living partners.
Imagine that a company has four shareholders all owning a 25% stake in the business and one of them decides to leave.
In that case, the buy sell agreement allows the shareholders to handle the exit of one of the shareholders without much conflict as they have already agreed on the following terms:
- 10% of the exiting shareholder’s shares will be redeemed and bought by the corporation
- The remaining 3 shareholders will each have the right to purchase 5% of the shares
- If a shareholder does not elect to buy the shares, the corporation will buy back that portion
- The closing of the transaction has to be within 30 days at the offices of the company
- The agreement has already provided a formula providing for the precise calculation of the value of the exiting partner’s shares taking into consideration the value of the business
Buy Sell Agreements Takeaways
So there you have it folks!
What is a buy-sell agreement?
What is the purpose of a buy-sell agreement?
What does it contain?
There are many reasons why you may want to enter into a buy-sell agreement.
Using the “buy-sell agreement”, you can define a trigger (also known as the triggering event) where a company can buy a partner’s shares or a partner can sell shares to the company.
The triggering events can be voluntary (such as a desire to leave the company or retirement) or involuntary (death, bankruptcy, disability, insanity, or other).
Companies are also protected as they can ensure they control the company ownership preventing outsiders or undesirable partners from becoming owners of the business.
In essence, with an agreement buy sell, business partners can manage the succession of partners or allow for partners to leave by minimizing conflict and dispute.
There are many benefits in having a buy/sell agreement in place, such as:
- Prevents potential conflicts and lawsuits
- Allows for a smooth and orderly transfer of ownership
- Allows for the business owners to consider tax consequences or maximize tax advantages
- Guarantees the business that no outsider may enter the company
- Allows for a company to have succession planning
- Allows for the business partners and company to agree on a method to value the shares
You may need an agreement buy sell when:
- You need to control the ownership interest of the company
- You want to manage involuntary events like disability, bankruptcy, or death
- You want to manage voluntary events like partners separation (partner “divorce”) or retirement
- You want to prevent outsiders from getting into the business
- You want to prevent the estate of a deceased partner to have any control over the business
- You want to have clarity on how the shares are to be valued
- You want clarity on how to manage the transition of ownership
I hope this article allowed you to get a better sense of the implications of a buy-sell agreement corporation, partnership, LLC, or any other type of business.
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