A buy/sell agreement is a legal arrangement between owners of a business outlining the process if an individual ceases involvement with the business.
The so-called triggering event could be the death or disability of an owner. It comes into play if an owner chooses to get out of the business. Other possible events include a divorce or an irreconcilable disagreement.
The Stark Advantage of Buy/Sell Agreements
The primary benefit is the procedure is predetermined at a time when calmer emotions prevail. It smooths the transition of the departure of an owner with legal and financial matters settled already. All the involved parties are on the same page, knowing the process will occur with the change in ownership.
For this reason alone, the agreement is priceless.
A buy/sell agreement is appropriate no matter what size business. In the case of a smaller business, it can handle the question of whether a spouse assumes management duties if an owner dies. With a larger business, it is essential—especially if there are multiple owners. It can ensure a business stays intact. It can also dictate future ownership.
Owners may prefer a business stays in the family rather than having outsiders buy into it. An agreement can stipulate those conditions as well as provide for the first right of refusal.
Regardless of who initiates the process, it should be fair to all parties. After all, no one knows which partner may be the object of the triggering event the agreement covers.
The Role of Life Insurance In Business
Life insurance often plays a key role in a buy/sell agreement.
The benefit from a policy is it can provide the immediate and necessary funding, ideally without any out-of-pocket cash. However, it’s crucial to consider where the business is headed and consequently, the amount of coverage which is necessary. This leads to one factor which requires careful consideration. Value.
Valuing the Business
The value of the business relates directly to the amount of life insurance needed. The buy/sell agreement could spell out a fixed valuation.
The figure will likely be inappropriate at the time of a later triggering event, especially if the owners made an agreement in the business’s earliest days. Alternatively, the agreement could include a formula on which to value the business, both now and later.
While the latter is a safer option, either method stands the risk of becoming outdated.
The best approach is to review the valuation of the business on an annual basis regardless of the means of valuation. The buy/sell agreement could also include a provision to have an unbiased professional appraisal done when necessary so the arrangement is fair to all involved.
Type of Agreement
Another consideration is the type of agreement.
An entity agreement involves a life insurance policy taken out by the business for the owners. The business will then pay the owner’s estate for his share should he pass away. In the case of a cross-purchase agreement, each business owner can buy a policy on the other owner with themselves as beneficiaries.
This way, all owners have the peace of mind knowing funding is available at the time of the transition.
Also, the buy/sell agreement can go so far as to address specific insurance issues such as the type of insurance. With these terms in place, the arrangement can alleviate some of the potential disagreements which may occur when the time comes.
Terms of the Sale
Life insurance comes into play once again with the terms of the sale.
An agreement can specify if a lump sum or installment plan is required for the purchase. The benefit of a policy becomes more attractive as a funding option in this scenario. Other matters to consider are the obligations to buy and sell between the owners.
This could mean a requirement to buy the share of the business in case of a triggering event. It may be structured as an option. An alternative is to give owners a right of first refusal to the buyer. It could also be a combination of these choices.
The buy/sell agreement may also address whether the owner’s family could take over the share of the business in case of death.
While many of these issues tread on sensitive ground, it makes good business sense to consider the most obvious scenarios and back them up with a plan. Since a buy/sell agreement is legally binding, it limits deviation from the course it sets.
Disability of an Owner
A buy/sell agreement should address the specific events that can signal a buyout.
The death of an owner is an obvious condition. But other events may also impact the business such as the disability of an owner.
For this reason, the owners should consider disability income insurance in addition to life insurance. Disability of an owner poses new questions an agreement can cover.
It’s essential for the interested parties to have a frank discussion about these aspects of a buy/sell agreement. It will likely be an emotional time if the event occurs. Language in the agreement can provide a mutually agreeable course of action to follow at this difficult time.
Also, it should define disability clearly to avoid any confusion.
In fairness to all owners, the buy/sell agreement may include provisions for income protection such as continuation of a salary for an agreed-upon time. The more precise the terms in the agreement, the easier it will be for all concerned. And it will help prevent the headaches and hassles occurring when emotions are involved in the matter.
Other Future Events
Business owners can enter into a simple buy/sell agreement only addressing a few events as the entity exists now.
But, it can also include other aspects of the future growth of the business.
For example, owners should consider whether the agreement applies to any additional owners the business takes on if it expands. An agreement could include these individuals too.
Amending the Agreement
Likewise, the agreement should have provisions covering any future changes which may come up with its annual review such as a change in valuation.
A provision allowing amendments can keep it current, so it adapts with the business as it grows. No one can predict the course it may take over time. Being able to alter the buy/sell agreement protects the business from future changes which would otherwise make it obsolete.
Changes in Valuation
With a healthy business, a change in valuation may mean additional life insurance coverage to cover the cost of a buyout.
It will behoove the owners to have a policy allowing for the benefit to grow without additional underwriting. This is essential because of the risk of increases in premiums or ineligibility for coverage if an owner’s health changes for the worse.
Disagreements Among Business Owners
Another consideration is the addition of provisions in the case of an irreconcilable disagreement.
While it is an uncomfortable topic, it is wise to include it, nevertheless. Failure to plan can cause irreparable damage to a business. It can act as a last resort to smooth the transition of a partner leaving the business while keeping it intact so it can survive.
As with planning one’s personal estate, a buy/sell agreement forces business owners to consider difficult matters.
However, as hard as it may seem, having a buy/sell agreement in place before a triggering event is infinitely easier than trying to make rational business decisions at an emotional time. The time and money spent in planning will be priceless.