A buy-sell agreement is a critical part of any small business plan, and it should not be overlooked. It is a legal agreement between the owners of a business that governs what happens if a partner dies, retires, or otherwise leaves the business. A well-drafted agreement will help the business avoid complications, misunderstandings, and disagreements down the road.
The specifics of the buy-sell agreement will depend on your unique business. It will take into account factors like the type of business entity (corporation, partnership, sole proprietorship, etc.), number of business owners, tax consequences, and the nature of the business. You should work together with a Phoenix business planning attorney to draft the buy-sell agreement, and the document should be reviewed and updated as your business changes and grows.
The key elements that you should address in a buy-sell agreement are outlined below.
Events That Will Trigger a Buyout
Your buy-sell agreement should include language that states when the contract will be triggered. You should consider all the possible scenarios that may arise. If a situation is not addressed, it leaves open the potential for uncertainty and conflict. Business owners should think about including the following triggering events:
- The business should confirm that the buy-sell agreement is consistent with estate plans to avoid conflicts with heirs.
- During a divorce, the court may order that the owner’s share of the business be split with the ex-spouse. The buy-sell agreement can include the right to buy out the business from a divorcing owner’s spouse.
- The business should define what disability means and what happens if a disabled owner recovers and wants to return to work.
- The business should define what retirement means and the age at which an owner can decide to retire.
Owner Leaving the Company
If a business owner declares personal bankruptcy, the bankruptcy court may allow creditors to pursue the bankrupt owner’s business shares to pay off debts. The buy-sell agreement can include an option to buy out the bankrupt owner’s shares.
How the Business Will Be Valued
A buy-sell agreement should clearly establish and define a fair purchase price for the owner’s interest. A business’s value is not static. When deciding how to value the company, it is important to take into account that it can change significantly over months and years. In general, there are three different approaches to value your business:
- State a specific value and require owners to agree annually to a new value;
- Use a clearly defined, self-adjusting formula; or
- Have the business professionally appraised, which can be expensive, but a third-party, unbiased opinion will lend credibility and limit disagreement.
It is also critical to identify what will be included in the valuation: physical assets, real estate, assets and debts, etc. Drafting a thorough agreement will help avoid miscommunications later.
How the Buyout Will be Funded
The buy-sell agreement should address how the buyout will be funded. You should not assume that the buyer will have cash at the time of the purchase or be able to borrow 100% of the purchase price. If you do not take the time to consider how the buy-sell agreement will be funded, you could end up leaving the business in a vulnerable position.
Life insurance is a commonly used funding vehicle. There are different methods of using life insurance to fund the agreement. For example, in a cross-purchase agreement, each shareholder owns the policy on each of the other shareholders. However, in an entity-purchase agreement, the business owns the insurance policy. It is important to work with a professional to set up the life insurance policy that works most effectively for your business.
Other potential funding options include a cash sale, installment payments over time, or deferred compensation arrangements to employees and owners. In certain situations, a combination of funding sources may be appropriate.
Who Can and Can’t Buy the Departing Owner’s Share of the Business?
The buy-sell agreement should outline who can and cannot be a buyer. There are several different options that you should consider. For instance, do you want the owners to have a right of first refusal (the right to buy the shares before they are offered to outsiders)? Do you want certain family members to retain ownership of the business?
Your Phoenix Business Planning Attorney
If you have questions about buy-sell agreements, you should contact a Phoenix business planning attorney. Nicole Pavlik is an experienced business planning attorney based in Phoenix, Arizona. Call Nicole Pavlik Law Firm today at 602-635-6176 to schedule a free consultation and discuss your business planning needs.