What Is a Buy and Sell Agreement?

A buy and sell agreement is a legally binding contract used to reallocate a share of a business if an owner dies or otherwise leaves the business. Also known as a buy-sell agreement, a buyout agreement, a business will, or a business prenup, buy and sell agreements are used by sole proprietorships, partnerships, and closed corporations to divide the business share or interest of a proprietor, partner, or shareholder.

In a buy and sell agreement, the owner of the business interest being considered for reallocation must be deceased, disabled, retired, or have expressed interest in selling. The buy and sell agreement requires that the business share is sold to the company or the remaining members of the business according to a predetermined formula. Before the interest of a deceased partner can be sold to the company or remaining partners, the deceased's estate must agree to sell.

Understanding Buy and Sell Agreements

The two most common forms of agreements are cross-purchase agreements and redemption agreements. In a cross-purchase agreement, remaining owners purchase the interests of the selling or deceased owner. In a redemption agreement, the business entity redeems the interests of the selling or deceased owner.

In order to ensure the availability of funds in the event of a partner's death, most parties will purchase life insurance policies on the other partners. In the event of a death, the proceeds from the life insurance policy are used to purchase a portion of the deceased's business interest. It is important to note that when a sole proprietor dies, a key employee can be designated as the buyer or successor since there are no business partners.

[Important: Partners should work with both an attorney and a certified public accountant when crafting a buy and sell agreement.]

Benefits of Buy and Sell Agreements

Terms of buy and sell agreements can help partners manage potentially difficult situations in ways that protect the business and the interest of the partners. For example, the agreement can restrict owners from selling their interests to outside investors without approval from the remaining owners. This protects the business and the remaining owners from outside investors who may have conflicting views or goals.

Similar protection also is provided in the unfortunate event of a partner's death. A typical agreement requires both that a deceased partner's interest be sold back to the business or the remaining owners and that the business or remaining owners must purchase the interests of the deceased owner. This prevents the deceased owner's interest from coming under the control of an estate that might have conflicting priorities.

In addition to controlling ownership of the business, buy and sell agreements spell out the terms for assessing value. Determining the means of assessing the company's value can have benefits other than executing a buy and sell agreement. For example, in a dispute among owners about the value of the company or the value of partners' interests, the valuation methods included in the buy and sell agreement would be used.

Key Takeaways

  • Buy and sell agreements stipulate the terms of reallocating a partner's share of a business in the event of that partner's death or departure.
  • Buy and sell agreements establish a method for determining a business' value.
  • Cross-purchase buy and sell agreements involve remaining owners buying the interests of a deceased or selling owner.
  • Redemption buy and sell agreements involve the business entity redeeming the interests of a deceased or selling owner.