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A buy-sell agreement does more than protect the business owner, it protects the business owner’s heirs.
Creating a buy-sell agreement for a business owner is a lot like a will—it needs to be updated to reflect changes in partnership agreements or the departure of the owner or a co-owner from the business. As reported in Country Journal’s article, “Drafting and reviewing your buy-sell agreement,” a buy-sell agreement is one part of a larger process of estate planning.
The idea behind a buy-sell agreement is to legally confer on the owners of a business or the business itself, the right or obligation to buy a departing owner’s interest. However, a professionally drafted agreement can also dictate that control of the business is restricted to specified individuals, like the current owners or a family member. In addition, a buy-sell agreement can set a price for the ownership interests. Finally, estate planning is also a top issue for many buy-sell agreements.
A buy-sell agreement can lie dormant for years, then a “triggering event,” like the retirement or death of an owner, brings the buy-sell agreement into play. However, other events like changes to marital status can also trigger the document, too. A buy-sell agreement can also address events like a criminal conviction, the loss of professional licensure or certification, or involvement in a situation deemed to be inappropriate or illegal.
If you haven’t drafted a buy-sell agreement for your business with your lawyer, you can now see the importance of doing so. Here are the structures and options for agreements:
- Redemption—permits or requires the business as a whole to repurchase an owner’s interest;
- Cross-purchase—permits or requires the remaining owners to buy the interest (usually pro rata), and
- Hybrid—combines the two other structures. For example, it might require a departing owner to first make a sale offer to the company and, if it declines, sell to the remaining individual owners.
You should also consider the tax implications when you draft your buy-sell agreement and its initial structure, because taxes will differ based on whether your company is a flow-through entity or a C-corp.
Buy-sell agreements need a funding source so the remaining owners can buy their former co-owner’s shares, and life insurance is commonly used. However, there are alternatives. A cash-rich company that’s confident in its future, could rely on its reserves. This could leave a business vulnerable to an unexpected cash shortfall. A “sinking fund” is another option. You set aside money for paying out the agreement over time.
The creation and updating of a buy-sell agreement does have associated costs, but if a triggering event occurs, it will more than pay for itself in both cost, time and stress.
Reference: Ohio’s Country Journal (June 14, 2017) “Drafting and reviewing your buy-sell agreement”