Buy/Sell Agreements: Why Every Business Partnership Needs One
Buy/Sell Agreements: Why Every Business Partnership Needs One
Written by AI, reviewed and approved by Michael Carson, Chief Compliance Officer
As a business owner, you've worked hard to build your company. But have you thought about what happens if a partner leaves due to retirement, disability, or even an unexpected death? Without a clear plan in place, ownership disputes, financial strain, or even the collapse of the business can occur.
A Buy/Sell Agreement is perfect for these circumstances. It's a crucial tool that ensures a smooth ownership transition and protects both the business and its owners from uncertainty. In this post, we'll break down what a Buy/Sell Agreement is, why it's essential, and how to set one up.
What is a Buy/Sell Agreement?
A Buy/Sell Agreement is a legally binding contract that outlines what happens to a business owner's share of the company if they exit due to specific events like death, disability, retirement, or disagreement.
At its core, this agreement:
✅ Defines what happens if an owner leaves or passes away.
✅ Sets a fair valuation method for the business.
✅ Ensures continuity and stability for the company.
✅ Prevents disputes between remaining owners and heirs.
Think of it as a business prenup—it's designed to prevent confusion and ensure an orderly transition when changes in ownership occur.
Key Elements of a Buy/Sell Agreement
A well-drafted Buy/Sell Agreement includes several key components:
1) Triggering Events - These are the situations that activate the agreement. Common triggering events include:
- Death of a business owner.
- Permanent disability or incapacitation.
- Retirement or voluntary exit.
- Divorce or bankruptcy, which could force an ownership transfer.
- Irreconcilable disputes between owners.
2) Valuation Method - Determining a fair price for the business is crucial. The agreement should specify how the business will be valued, using methods such as:
- Fixed Price – A predetermined dollar amount.
- Formula Method – A calculation based on revenue, profit, or assets.
- Independent Appraisal – A professional valuation conducted at the time of transfer.
3) Funding Mechanism - Funding the buyout is one of the most critical aspects of a Buy/Sell Agreement. Options include:
- Life Insurance – The company or owners take out life insurance policies to fund the buyout in case of death.
- Installment Payments – The departing owner or their heirs receive payments over time.
- Company Reserves – The business sets aside funds for future buyouts.
4) Ownership Restrictions - To prevent unwanted outside influence, most agreements include clauses restricting owners from selling shares to external buyers without first offering them to existing owners or the business itself.
Types of Buy/Sell Agreements
There are three main types of Buy/Sell Agreements:
1) Cross-Purchase Agreement
- Each owner agrees to buy the departing owner's share.
- Typically used in businesses with a small number of owners.
- Often funded by life insurance policies taken out by owners on each other.
✅ Example: Two business partners each take out life insurance on one another. If one passes away, the other uses the policy payout to buy their shares.
2) Entity Purchase (Redemption) Agreement
- The business itself buys back the departing owner's share.
- Ideal for companies with multiple owners.
- The company typically takes out life insurance on the owners to fund the buyout.
✅ Example: A company with four partners buys a life insurance policy on each. If one partner dies, the business receives the payout to buy back the deceased partner's shares.
3) Hybrid Agreement
- A combination of the cross-purchase and entity purchase agreements.
- Allows flexibility— the company or individual owners can purchase the departing owner's interest.
✅ Example: The business has the first right to buy an owner's shares, but the remaining owners can step in if it declines.
Why Business Owners Need a Buy/Sell Agreement - Not having a Buy/Sell Agreement can lead to serious problems, including:
- Disputes among owners and heirs – Without clear guidelines, family members may inherit shares and clash with existing owners.
- Financial strain on the business – If a partner dies and the company can't afford to buy back shares, it could face instability or liquidation.
- Legal battles and uncertainty – Resolving ownership issues can be expensive and time-consuming without a formal agreement.
✅ Real-World Example: A family-owned business faced turmoil when one partner unexpectedly passed away. His spouse inherited his shares but had no interest in running the company. The remaining owners struggled to buy her out, leading to legal battles and financial strain. A Buy/Sell Agreement could have prevented this.
How to Set Up a Buy/Sell Agreement - Creating a Buy/Sell Agreement involves working with legal and financial professionals. Here's a step-by-step approach:
Step 1: Identify Key Owners & Stakeholders - Determine who the agreement will apply to (partners, shareholders, etc.).
Step 2: Define Triggering Events - Clearly outline the events that will activate the agreement
Step 3: Establish a Valuation Method - Work with your financial planner, CPA, and other experts to determine how the business will be valued.
Step 4: Choose a Funding Mechanism - Decide how the buyout will be financed (e.g., life insurance, installment payments).
Step 5: Set Ownership Restrictions - Determine if shares can be sold externally or only to current owners.
Step 6: Draft the Agreement with Legal Professionals - Hire an attorney to formalize the agreement and ensure compliance with state laws.
Step 7: Review & Update Regularly - Revisit the agreement every few years to keep it aligned with business growth and ownership changes.
Conclusion & Call to Action
A Buy/Sell Agreement isn't just a legal document—it's a critical safeguard for your business. It ensures stability, protects your investment, and prevents unnecessary disputes in times of change.
If you don't have one in place, now is the time to act. Work with your attorney and financial advisor to create a Buy/Sell Agreement tailored to your business. Don't wait for a crisis—protect your company's future today.
