What Is a Buy and Sell Agreement?
A buy and sell agreement (or buy-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. Most often, the buy and sell agreement stipulates that the available share be sold to the remaining partners or to the partnership. Buy-sell agreements often use life insurance policies to fund the potential buyout in the event of a partner's death.
A buy and sell agreement may also be called a buyout agreement, a business will, or a business prenup.
- Buy and sell agreements stipulate how a partner's share of a business may be transferred in the event of the partner's death or departure.
- Buy and sell agreements may also establish a method for determining the value of a business.
- The most common buy and sell agreements are cross-purchase, and entity-purchase (redemption); some agreements will combine the two.
- Cross-purchase agreements allow remaining owners to buy the interests of a deceased or selling owner.
- Redemption agreements require the business entity to buy the interests of the selling owner.
How a Buy and Sell Agreement Works
Buy and sell agreements are commonly used by sole proprietorships, partnerships, and closed corporations in an attempt to smooth transitions in ownership when a partner dies, retires, or decides to exit the business.
The buy and sell agreement requires that the business share be sold to the company or the remaining members of the business according to a predetermined formula. In the case of the death of a partner, the estate must agree to sell. To fund the purchase of the shares by the surviving partners, life insurance policies are taken out reciprocally by each partner on the lives of the others, which can be paid for by the company as a business expense, where the partners are the named beneficiaries.
Upon the death of a partner, the life insurance death benefit will be paid out to the remaining partners, who will use the funds to purchase the deceased's shares from their estate, ensuring continuity of the business and its ownership structure. Having a buy-sell agreement avoids costly battles for control with surviving spouses or children and having to use probate court.
Types of Buy-Sell Agreements
There are two common forms of buy-sell agreements:
- In a cross-purchase agreement, the remaining owners or partners purchase the share of the business that is for sale.
- In an entity-purchase agreement (also known as a redemption agreement), the business entity itself buys the deceased's share of the business.
Some partners also opt for a mix of the two, with some portions available for purchase by individual partners and the remainder bought by the partnership.
A wait-and-see agreement combines elements from each of these two, where neither the partners nor the entity is explicitly named. At the time when it becomes necessary, the agreement will become either one or the other depending on what's best for business continuity.
When a sole proprietor dies, a key employee may be designated as the buyer or successor.
Partners should work with both an attorney and a certified public accountant when crafting a buy and sell agreement, along with a life insurance professional.
Key Considerations in Buy-Sell Agreements
Buy and sell agreements are designed to help partners manage potentially difficult situations in ways that protect the business and their own personal and family interests.
For example, the agreement can restrict owners from selling their interests to outside investors without approval from the remaining owners. Similar protection can be provided in the event of a partner's death.
A typical agreement might stipulate that a deceased partner's interest be sold back to the business or remaining owners. This prevents the estate from selling the interest to an outsider.
In addition to controlling ownership of the business, buy and sell agreements spell out the means to be used in assessing the value of a partner's share. This can have uses outside the question of buying and selling shares. For example, if there is a dispute among owners about the value of the company or of a partner's interest, the valuation methods included in the buy and sell agreement would be used.
Buy-Sell Agreement Templates
There are several online resources that offer low-cost or free templates for drawing up a buy-sell agreement. which can be especially useful for new or small companies. As your business grows or if it has a large number of partners from the onset, it is better to have a lawyer draft the document.
How Do You Establish a Buy and Sell Agreement?
A buy-sell agreement is a contract that sets out how a partner's shares will be obtained by the remaining partners or owners of a firm in case of their death or departure. This is usually done with the aid of a knowledgeable attorney.
In order to ensure that funds are available, partners in business commonly purchase life insurance policies on the other partners. In the event of a death, the proceeds from the policy will be used towards the purchase of the deceased's business interest. This part of the agreement should be done through a life insurance agent with experience in this type of agreement.
What Should Be Included in a Buy and Sell Agreement?
The following pieces of information should be spelled out in a buy and sell agreement:
- a list of triggering buyout events, including death, permanent disability, bankruptcy or retirement, etc.
- a list of partners or owners involved and their current equity stakes
- a recent valuation of the company's overall equity
- a funding instrument, such as life insurance policies
- tax and estate planning considerations for the individual partners and surviving beneficiaries
What Is the Benefit of a Buy and Sell Agreement?
A buy and sell agreement assures a smooth transition of ownership and business continuity in the event of a departure of a partner or large equity owner. The agreement is a legally-binding contract that establishes how the departing owners' shares will be obtained by the remaining partners. Without such an agreement, there can be legal battles and contestation. For instance, if a partner dies without an agreement, their shares may be passed automatically to their spouse, who may decide to keep them. Or, the spouse may want to sell them, but the remaining partners do not have the funds available to buy the shares.
The Bottom Line
Business continuity is important, especially when there are multiple partners or important equity holders involved in the running of a business. A buy and sell agreement (buy-sell agreement) is a legal remedy for establishing a clear plan of how to distribute the shares of a departed or deceased partner to the remaining ones. In the case of a death, life insurance policies are used to fund the buyout of shares from the deceased's estate.