All business owners know how much time and effort goes into growing a successful enterprise. They meticulously run the day-to-day operations and set long-term goals, focusing on priorities from increasing revenue to fostering a customer-centered culture. But surprisingly few entrepreneurs plan for an inevitability in the business life cycle: succession planning. That is, what will happen to the business if one partner steps aside? The dissolution of a business partnership is not uncommon, but regardless, few companies are structured to manage these types of transitions when and if they become necessary.
Planning for a business partner’s departure is an essential step in running a venture that is set up for long-term profitability, scalability, and success. That is why every business with more than one owner should have a buy-sell agreement in place. Whether you have not yet formed the business or are in the middle of operating one, an attorney can help you draft a buy-sell agreement to protect the business when one partner departs it. Here, we give an overview of buy-sell agreements, discuss the key provisions, and explain why you should contact an attorney today to discuss drafting a buy-sell agreement for your business.
What Is a Buy-Sell Agreement?
While it is not always an easy conversation to have, business partners should have a frank discussion about what will happen to the business should one partner depart. A buy-sell agreement is essentially a legally binding representation of that agreement among business partners. Buy-sell agreements have been described by some as “business prenups” since they lay out how a business will divide up its ownership assets upon the “divorce” of any of its partners.
On a more specific, granular level, a buy-sell agreement is a document or provision within another document (such as a shareholder’s agreement or LLC operating agreement) that details what will happen when one owner can no longer be an owner or no longer wants to be one. Usually, this occurs when an owner dies, becomes disabled, or wants to retire. The agreement will detail how ownership will be reallocated to the remaining partners or another pre-designated owner or manager.
Key Provisions of a Buy-Sell Agreement
The primary purpose of the buy-sell agreement is clarity: for business owners, the goal is to create a clear, detailed roadmap for managers upon a partner’s departure. In other words, the goal is for there to be no mystery about how the business will handle its affairs. The agreement details exactly what will happen upon this event, instead of leaving it up to future negotiation, an executor of an estate, or even the courts. While a buy-sell agreement’s specific provisions will vary based on the business’ needs, there are a few key provisions that appear in most:
- Triggering Events
Triggering events are those that activate the provisions of the buy-sell agreement, that is, the events that result in the right or obligation of someone else to purchase the departing partner’s ownership interest. These usually include, for instance, death, disability, divorce, bankruptcy, and retirement. - Obligation or Rights to Purchase
When a triggering event takes place, the buy-sell agreement will detail what happens next. Usually, this is either (a) the obligation that the remaining partner(s) buy out the leaving partner or (b) the rights of the remaining partner(s) to buy out the departing partner. - Valuation
Nobody wants to argue over money when a triggering event has occurred. For that reason, it is important to include an agreement about how to value and allocate ownership. This might include an agreement that an outside business valuation expert value the business at the time of the triggering event or provide another method for determining the purchase price. - Funding Terms
These terms set forth how the departing owner will be paid for his or her shares. This often includes the application of insurance proceeds since many business owners obtain insurance coverage on the life or disability of the other owners. Another common term authorizes the company to use its cash reserves to buy out the leaving owner.
Does Your Business Need a Buy-Sell Agreement?
While there is no legal requirement that your business implements a buy-sell agreement, there are nonetheless a few compelling reasons to do so:
- Buy-sell agreements prevent owners from transferring ownership to a party the other owners would not want to engage. For example, upon an owner’s divorce or death, the owner’s spouse could acquire control of his shares. A buy-sell agreement would prevent that spouse from retaining ownership if the other business partners would prefer to avoid embroiling family members in the business’ affairs.
- Buy-sell agreements prevent costly litigation. Disputes among business owners are common. While this hopefully will not happen to your business, a buy-sell agreement can make an owner’s departure from the business less contentious and help you avoid litigation over issues such as valuation.
- The departure of a business owner, and the transfer of ownership to a new owner, can cause unintended tax consequences. A well-structured buy-sell agreement can help owners avoid any tax surprises that may arise by virtue of a substantial change in business ownership.
How a Business Formation Attorney Can Help Your Business Draft a Buy-Sell Agreement
Whether your business is still a nascent idea or a booming enterprise, a business formation attorney can help you draft a buy-sell agreement tailored to your specific needs. Because these agreements can be complex, it is best to engage professional help to ensure you are planning for every possible contingency. This is the best way to prepare your venture for long-term success.