Buy-Sell Agreements: What Every Business Owner Should Know
As a business owner, you focus your time and energy on the growth and daily operation of your business. Consequently, it can be challenging to find the time to think about its long-term future. But having a plan in place to ensure the continuity of your business should anything happen to you is essential. For many business owners, this plan involves setting up a buy-sell agreement.
To help you determine if such an agreement is right for your business, it’s important to understand what it is, how it works, and the funding methods available.
What Is a Buy-Sell Agreement?
A buy-sell agreement ensures business continuity if the owner becomes disabled, decides to retire, or passes away unexpectedly. It outlines the parties involved in the agreement, describes the events that trigger a transfer, and lays out an agreed-upon value of the business. Having this kind of agreement in place can help avoid rushed decisions during what can be a stressful time. Plus, knowing the company has a plan in place provides assurance to its employees and instills confidence in its customers that the business will remain strong.
Structuring the Agreement
There are several ways to construct a buy-sell agreement. The best choice for you will depend on your company’s structure and ownership:
- Cross purchase: Another business partner agrees to purchase the business from the owner or the owner’s family.
- Entity purchase: The business entity agrees to purchase the business from the owner or the owner’s family.
- Wait-and-see: The buyer of the business is allowed to remain unspecified, and a plan is put in place to decide on a buyer at the time of a triggering event (e.g., retirement, disability, death).
After a triggering event occurs, either the business entity or another party will begin the process of purchasing all or a portion of the business, based upon the valuation described in the agreement.
It’s important to include funding details in a buy-sell agreement to ensure a successful transfer and to keep the business running smoothly. Common funding methods include cash or assets of the business, a loan, and installment payments, as well as employee stock ownership plans (ESOPs) and insurance.
ESOPs. When selling a business to employees, an ESOP can be established to help provide a source of funds. An ESOP requires specialized administration to navigate the complexity of the agreement and to comply with the applicable rules and regulations. Candidates for an ESOP generally fit within the following guidelines:
- Privately held, profitable C or S corporation
- More than 30 employees
- Value of at least $3 million
- Established management team and strong cash flow history
Life and disability insurance. Insurance provides liquidity to help the business during a challenging situation or to purchase the business from a grieving family. Depending on the structure of the company and the type of buy-sell agreement, the business may be able to pay the premium, or bonuses may be given to those policy owners who pay the premiums.
- In a cross-purchase agreement, all business owners will purchase, own, and be the beneficiary of an insurance policy insuring each of the other business owners. This type of agreement may not be appealing for a business that has multiple owners, as it requires several policies to be purchased. For example, if there are 4 business owners, a total of 12 insurance policies would be needed.
- With an entity purchase agreement, the insurance policy is usually owned by the business. Even with multiple owners, only one policy per owner is needed.
- In wait-and-see agreements, the policy ownership and beneficiary structures vary, depending on the type of the agreement that is ultimately put in place.
When determining if a buy-sell agreement would work for your business, keep these considerations in mind to help you make the best choices for your company, your partners, and your employees. If you do move forward with a buy-sell agreement, be sure to consult with an attorney and a tax advisor to develop a plan that best serves the needs of your business. Once the agreement is in place, don’t forget to review it every few years to ensure that it accommodates any changes that may have occurred.