While it may be unpleasant to think about, what would happen to your business if you become incapacitated or pass away? In this situation, a buy-sell agreement would be invaluable.
Buy-sell agreements allow business owners who are deceased, disabled, or face another unexpected life event to sell their share of the business. They can also serve as exit plans for partners who no longer wish to have a stake in their organization. Here’s everything you need to know about buy-sell agreements.
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that outlines what will happen to a partner’s share if they pass away or otherwise leave their business. Often referred to as a combination between a corporate prenup and will, a buy-sell agreement can ensure the business that you’ve worked so hard to build is protected.
A buy-sell agreement considers your preferences and gives you control of what will happen to your business entity if an unexpected event occurs. If you don’t have one, the courts or executors will make decisions on your behalf.
Types of Buy-Sell Agreements
Now that you understand the buy-sell agreement definition, here’s a brief overview of the three types of buy-sell agreements that exist.
- Cross-Purchase Agreement: In a cross-purchase agreement, the remaining owners agree to buy out the shares of the deceased or exiting owner for a certain price. It’s the simplest buy-sell agreement and ideal for businesses with only a few owners.
- Redemption Agreement: A redemption agreement is when a business buys the shares of the deceased or exiting owner. In most cases, they’ll use their life insurance funds to do so.
- Hybrid Agreement: Hence its name, a hybrid agreement is a hybrid between the cross-purchase and redemption agreement. It’s where the partners purchase some of the shares and the business buys the rest of them.
Benefits of a Buy-Sell Agreement
While a buy-sell agreement takes time and effort to create, it’s well worth it. If you have one, you can reap the following notable benefits:
- Maintain Business Continuity: A buy-sell agreement will eliminate confusion and chaos after a triggering event. This is because it will clearly explain what will happen if an unexpected death, illness, or sale of a portion of the business arises.
- Reduces Disputes: With a buy-sell agreement, you may minimize disputes with your family and the remaining business partners. It will keep everyone on the same page.
- Takes Care of Your Loved Ones: A buy-sell agreement will outline how your spouse and children will benefit from your investment in the business. It can alleviate their uncertainty if you as the owner dies.
- Protects Business Ownership: Since a buy-sell agreement lays out a succession plan, it saves remaining shareholders from the burden of having to make certain decisions. Decisions that sit well with the spouse or children of the deceased or exiting owner.
How to Set Up a Buy-Sell Agreement
To design a buy-sell agreement, you should meet with your business partners as well as a CPA or accountant and valuation expert. Once you’ve met with them, follow the steps below.
1. Consider Your Particular Business Needs
Your business and involvement in it is unique so it only makes sense that your buy-sell agreement is unique as well. Ask yourself what you hope to happen if you are no longer part of your organization. Your answer should be feasible for your specific organization.
2. Invest in Life Insurance
With a life-insurance policy, other parties will have access to the money they need to buy you out in the event of a death or disability. Since there are many types of life insurance companies and policies, do your research. Compare the options at your disposal and weigh the pros and cons of each before you buy a policy.
3. Don’t Forget a Valuation Clause
The valuation clause is one of the most important elements of a buy-sell agreement. It describes how you’ll calculate your value if you’re no longer a part of it. You can create your own valuation clause or opt for the outside opinion of a valuation expert who can establish one on your behalf.
4. Keep Taxes and Corporate Structure in Mind
If you sell your business, estate taxes can significantly reduce the amount of money you’ll receive. To avoid large, unexpected tax surprises, choose the right corporate structure. Since a corporation can hold interests in specific trusts, the most tax-efficient option would be the buyer buying out the seller. If you own a regular corporation, it would probably be better if the business buys out the seller.
A Buy-Sell Agreement is Essential for Business Owners
To protect your interests and reduce the risk of potential conflict with other business owners, a buy-sell agreement is imperative. It’s a formal, written document that can allow you to plan for unexpected events like death, disability, or divorce. A buy-sell agreement may be just what you, your family, and fellow owners need to gain some much needed peace of mind.