Buy-Sell Agreements: Should My Company Have One?
The short answer: if you are not the sole owner, then probably yes. Many types of businesses rely on collective ownership to reduce the tax-burden, lessen the day-to-day responsibility, and minimize liability for individual owners. While these types of business structures certainly have their benefits, buying/selling ownership shares among partners can get complicated and legally drawn-out.
For instance, say you and eight other partners collectively own a thriving limited liability company (LLC). What would happen if one of the partners unexpectedly passes-away? Who would be capable of buying their shares? And for what price? A similar situation occurs any time a partner leaves the company—whether they simply wish to sever ties, or perhaps they were criminally convicted and being forced to out. The central question is: when a partner disassociates from the company, what do we do with their shares?
This is a relatively simple problem if there is up-to-date documentation—such as a buy-sell agreement—that mandates the procedure for ownership changes. However, if there is no agreed-upon terms or conditions, coming to a fair conclusion after-the-fact is often difficult, emotionally-charged, and requires assistance from a legal professional.
What is a Buy-Sell Agreement?
A buy-sell agreement—also commonly called a buyout agreement, a business continuation agreement, or a business will—is a legally-binding contract that establishes the terms and procedures should a partner (for any reason) leave the company. As with any legally-binding document, it is important that the buy-sell agreement is written with clarity, concision, and preferably with a lawyer’s expertise.
Furthermore, it’s perhaps equally important that the agreement is regularly reviewed. Companies fluctuate over time, and since the buy-sell agreement sets the price that newly-available shares are sold for, it’s important to keep the buy-sell terms commensurate with the most-recent valuations (although one way around this is to use a formula to determine the purchasing price, instead of a hard-number).
Determining the purchasing price per share isn’t the only objective of the buy-sell agreement. All agreements should include three key provisions:
1. Who can Purchase the Newly-Available Shares
2. The Price that the Newly-Available Shares will be Sold for
3. The “Trigger” Events that will Facilitate the Buy-Out Process
In terms of who can purchase the departing member’s shares, there are usually two options: either the remaining partners will purchase the shares, or the business will purchase the shares. In rarer instances, the available shares will be offered to outsiders (however this doesn’t happen often).
The share price can be hotly-contested if it’s not established in the buy-sell. For this reason, using a formula or a recent valuation to determine a realistic price is paramount. Setting a price after-the-fact usually leads to costly and time-consuming legal disputes.
Finally, the agreement must establish under what circumstances these shares will become available. These are commonly called “trigger” events, because they trigger the process of ownership restructuring. Some of the more common trigger events include death or permanent disability, retirement, resignation, criminal convection, or bankruptcy. In these situations—so long as they’re established in the buy-sell agreement—partners will dissociate themselves from the company and their shares will be sold to eligible buyers (in accordance to the buy-sell agreement) at a predetermined price (also in accordance to the buy-sell agreement).
Although any of these trigger events are indeed plausible, the death of a partner is by-far the most common incident that facilitates the transfer of shares. Because of the frequency of these scenarios, many financial experts suggest an insured buy–sell agreement be established for the predictable transition of ownership in the event of a partner’s death.
The Insured—Buy-Sell Agreement
In the event of a partner’s death, the insured-buy-sell agreement allows others (either the remaining partners or the business) to purchase the newly-available shares through life insurance benefits. Although this may sound complicated, there are a number of advantages to insured-buy-sell agreements. Chiefly, it ensures that the purchase of shares is plausible and well-funded.
There are a few ways to execute an insured-buy-sell agreement. The first, commonly called the criss-cross purchasing method, requires that each partner be the owner and beneficiary of a life insurance policy for each of the other partners. In the case of a trigger event (ie. one partner passes-away), each of the remaining partners will receive a life insurance death benefit, which could then be used to purchase the newly-available shares of the deceased partner.
Another common insured-buy-sell framework is the promissory note method. Here, instead of partners owning policies on one-another, the business is the owner and beneficiary of life insurance policies on each of the partners. Upon the passing of a partner, the business would receive a death benefit amount, the remaining partners would purchase (via a promissory note) the remaining shares, and then they would be reimbursed as a tax-free capitol dividend from the business. The remaining partners would then use that dividend to repay the promissory notes.
Always be Prepared
In either scenario, the funds to purchase the shares are available because a buy-sell agreement was established far prior to the death of a partner. Insured-buy-sell agreements (in-fact, any buy-sell agreements for that matter) are nearly-impossible to draft after the event of a partner’s departure.
For that reason, it’s strongly encouraged that an attorney gets involved early in the process, and that a buy-sell agreement is established either in the company’s formation documents or as a stand-alone contract.