How does a buy-sell agreement work?

Essentially, a buy-sell agreement also called a buyout agreement or shareholder agreement, is a legally binding contract between a business and its owners that stipulates what will happen if an owner wants or needs to sell their part of the company. 

This also includes what happens to their part of the company if an owner dies, becomes disabled, retires, declares bankruptcy, or gets divorced. The agreement outlines when an owner can sell their interest, who can buy it, and what the price will be. 

What key elements should you include in a buy-sell agreement?

A good buy-sell agreement should include the following:

  • In what circumstances or identifiable situations an owner or business may dispose of ownership interests.
  • Call rights (allowing the business to purchase the owner’s interest at any time and setting the price at which they may do so—for example, 125% of fair market value).
  • Put rights (allowing an owner to demand the business purchase their interest at a loss).
  • Deadlock provisions (outlining what happens if an owner wants to leave but cannot reach an amicable agreement with the other owners).
  • Right of first refusal (allowing the business or other owners to refuse or waive their right to purchase an interest before an owner is permitted to sell to an outside party).

Other critical elements of a strong agreement include taxation considerations and funding resources. Finally, the valuation of a company can change significantly in a relatively short time, so the buy-sell agreement should be flexible in its ability to reflect changes in value accurately.

What are the different types of buy-sell agreements?

There are several types of buy-sell agreements, including:

  • Cross-purchase agreements, which allow shareholders to purchase a partner’s stocks if a triggering event should occur
  • Stock-redemption agreements, in which the company takes out life insurance policies on each of the owners and buys out an owner’s interest in the event of a death
  • Hybrid buy-sell agreements, or wait-and-see agreements, which provides flexibility by allowing owners to wait to choose a cross-purchase agreement and stock redemption until later
  • Company purchase agreements, which outline the terms and conditions of a transfer of ownership following a triggering event
  • Asset purchase agreements, which may fall under a buy-sell agreement where a transfer of assets is involved

Funding for buy-sell agreements is frequently arranged using insurance policies under a cross-purchase agreement or a stock redemption agreement. These are also the most common types of buy-sell agreements.

There are advantages and disadvantages to each approach (see below). 

Cross-Purchase Agreement

Advantages Disadvantages
Life insurance proceeds are not taxable to the beneficiary, and the decedent’s estate gets a stepped-up basis in the ownership interest. The transaction does not result in tax liability for either party. Because older owners’ life insurance premiums will be higher, a disparity in cost is created between older and younger owners.
The transactions occur outside the company. The life insurance proceeds are not subject to claims of the company’s creditors. The agreements must bind the beneficiaries to the agreed-upon transactions, such as selling the deceased owner’s interest.
The FMV of the interest acquired increases the basis of the remaining owners. Control can shift when ownership transfers occur under a cross-purchase agreement.

Stock-Redemption Agreement

Advantages Disadvantages
Simple to administer with fewer policies required than with a cross-purchase agreement. For a C corporation, insurance proceeds increase earnings and profits (E&P), resulting in taxation upon distribution to shareholders.
The cost of policies is split evenly among owners. Rules about stock redemptions can be complex. Related-party rules can cause unintended consequences.
For a C corporation, the proceeds are not taxable income. The remaining owners do not benefit from a step-up of basis.
Policies are not subject to the claims of the owner’s creditors. Those with the highest shares of ownership pay the most for premiums.

How do you set up a buy-sell agreement?

A buy-sell agreement is complex, important, and not something you should attempt to draft yourself.

It’s crucial that you seek the assistance of sound and trusted contract lawyers to draft the document. They will work with all parties in drafting, negotiating, and executing the terms of the agreement. It is also a good idea for each party to retain their own counsel during this period.

There are some steps you can take to make the process of setting up a buy-sell agreement smoother. For example, include a valuation clause, which will determine how the value of a stake in the company will be calculated upon a triggering event. You may want to consider including your business’s own valuation methodology in the agreement itself.

Additionally, it’s critical that you pay attention to the tax implications. Again, an honest, conservative valuation methodology can be helpful here to reduce avoidable tax liability in the event of a sale.

Finally, it’s usually a good idea for all partners to take out life insurance policies against each other. This provides the means for a partner to access money to buy out a co-owner in the event of death or disability.

Failing to invest in the services of a contract lawyer in drafting a buy-sell agreement is one of the biggest mistakes you can make (aside from failing to have an agreement in the first place). However, there are other potential pitfalls you should be aware of. Such as…

The 3 most common buy-sell agreement mistakes

While these are not the only mistakes that could cause costly issues with your buy-sell agreement, they are three of the most common. Be on the lookout to avoid making the mistake of…

1. Not addressing triggering events

No matter much work you put into perfecting the terms of your buy-sell agreement, it won’t be of much help if the agreement itself doesn’t cover the event that triggers the agreement. Failing to address the trigger event specifically will leave you and the other owners with a time-consuming and challenging negotiation—precisely what the agreement should help you avoid! 

At the least, your agreement should cover these seven key areas: death, disability, divorce, voluntary separation, involuntary separation, bankruptcy, and retirement. 

If other circumstances apply to your particular business, make sure you take those under consideration, as well. 

2. Vague or outdated valuation processes

As touched on above, specificity in the valuation can be beneficial in a host of scenarios. Overall, however, agreeing on how much the business is worth is one of the biggest hurdles you’ll face in your transaction unless you have anticipated it in your buy-sell agreement. 

It’s not enough to refer to a “stated value” or promise to hire the world’s best valuation analysts when the time comes. Your agreement should formalize a methodology, formula, or process for valuation. For example, one common approach is to establish proactive valuation regularly. 

3. A one-size-fits-all approach

An effective buy-sell agreement is carefully and thoughtfully customized for the unique characteristics of your business. Too many business owners are content to find a simple template online and fill in the blanks. Unfortunately, that is just not going to be effective. 

The best buy-sell agreements are the products of time, consideration, collaboration, and professional legal counsel and are specific, comprehensive, and accurate. 

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