Not having a buy/sell agreement is one of the worst mistakes a small business can make. The buy/sell agreement protects the future of the business by defining the rights and obligations of co-owners in the event that one owner exits for any number of reasons, including death, disability, retirement, the development of a dispute, or a simple desire to pursue new ventures. A well drafted buy/sell agreement should do four things:
- define the triggers for the sale of an interest,
- set the price,
- establish a funding mechanism for the sale and
- consider tax consequences.
What Events Might Trigger the Sale of an Interest in a Business?
Consider the chaos if one of three co-owners actively running a business died without a will. His or her interest would be included in the estate and eventually distributed to heirs when probate is complete. A long process might prevent other owners from running the business, disrupting an income stream to those who depend on it. The process could also leave the wastrel cousin with control of a company he cares nothing about. Negotiating to buy out the cousin completes the ruin. Why would any businessperson do this to a carefully nurtured enterprise?
A buy/sell agreement may define the events that would trigger the co-owners’ right to buy back an existing owner's interest in the business, termed a “call.” This might be appropriate where management has become deadlocked because of a dispute.
The agreement may also define the events that would give an exiting owner the right to compel the remaining owners to buy that interest, termed a “put”. This situation might arise when an owner wants to retire.
How to Set the Price
With small businesses, there often is no market for a share other than among the co-owners, whose interest is, nonetheless, quite urgent. The existence of a buy/sell agreement allows the parties to set a formula under which the price will be determined in the future. This may take the strain out of negotiation at a time when customers, clients and employees may require reassurance.
How To Finance the Buy Back
The co-owners of a business, or the business itself, may insure the lives of the owners. On the death of an owner, the proceeds of the policy may be used to purchase the deceased owner’s interest in the business. The financing arrangements underpinning the buy/sell agreement usually take the form of some combination of insurance and other sources of capital.
Those other sources may include borrowed funds or even vendor financing, the availability of which is less certain. Co-owners should consider whether a lump-sum or installment payments would be better and whether a promise to pay out over time should be secured in any way.
Finally, it is important to consider who will own the exiting owner’s interest — whether it will be divided according to some formula among the remaining owners or whether it will be owned by the enterprise, itself. A third option, of course, would be to require that the entire business be sold on the occurrence of a named contingency.
The Buy/Sell Agreement Should be Part of a Larger Plan
An experienced attorney should be an integral part of the planning process, especially since the design of the buy/sell agreement may have important tax consequences.
In the best of all possible worlds, succession planning, including the execution of a buy/sell agreement would take place early in the life cycle of a business, and not in a vacuum. Perhaps all owners should also sign non-compete agreements. This would also be a very good time to review individual estate plans. This kind of comprehensive business planning should also be revisited periodically to ensure that it continues to reflect the goals and current situation of all involved.