What is a Buy-Sell Agreement?
Written by Peter McFarland, Esq. on 6/6/14
It’s exciting to start a new business. But starting a new business takes so much time and energy, we’ve noticed that our clients often don’t focus on their exit strategies. Important life events can have a large impact on a business and ultimately shape the business’ future. Death, disability, divorce, and retirement all need to be taken into account and contingency plans for each must be established.
What is the Agreement?
Known colloquially as a business prenup, a Buy-Sell agreement is a legally binding contract between business owners to sell and purchase a business owner’s interest under very specific circumstances, including his or her death or disability. It is most often executed separately from the Operating Agreement or Bylaws and will specifically override such other agreements as necessary.
How Does it Work?
There are many different ways to structure a Buy-Sell agreement, and it is best to consult with a professional who has experience drafting these agreements to determine what plan would work the best for your specific situation.
A common method, however, is to have the other owners purchase the exiting member’s interest. Another strategy would be for the company itself purchase the interest. There are two major components of structuring a transaction either way.
First, the owners must agree upon a valuation for the owner’s interest in the company. Some clients prefer to hire appraisers while others rely on a valuation based upon the previous year’s profit. Still other clients prefer a hybrid approach, where the valuation may change depending on whether life insurance proceeds are available (more on that later).
Second, the business owners must determine how the purchase price will be funded. Some clients prefer to self-fund the purchase of the interest and set up installment payments for the seller to be bought-out over the course of several years. Other clients prefer to utilize insurance to pay the amount that may become due under the agreement.
What is a Common Way to Deal with the Death of an Owner?
A very common method of funding the purchase of a deceased owner’s interest in the company is to have the company or other owners purchase life insurance on the owner’s life before he or she dies. The Buy-Sell agreement would then value the owner’s interest at the face-value of the life insurance policy. When the life insurance company pays the insurance proceeds, the proceeds are paid to the deceased owner’s family and the estate of the deceased member sells the ownership interest back to the company or to the remaining owners.
There is a huge advantage to this kind of set-up. With life insurance in place, owners can rest assured that there will be adequate funding in place to purchase the owner’s interest in the company. From an estate planning perspective, as well, an owner can have some piece of mind knowing that there will be a nice settlement paid to his or her beneficiaries upon his or her passing.
What Happens if an Owner becomes Disabled?
A very common means of dealing with disability is similar to the life insurance route mentioned above. The company purchases disability income insurance on the life of the owners. The agreement would be drafted to take advantage of such insurance, and provide for a buy-out period where the proceeds of the disability insurance is used as an installment payment to purchase the interest of the disabled owner in the company over a set period of time.
Like the life-insurance plan set forth above, the disability income insurance provides a definite source of funding for the purchase of the ownership interest. Without insurance, it is left to the company or other owners to fund the purchase of the ownership interest themselves.
What About an Owner Who Just Simply Wants to Quit?
Buy-Sell agreements can plan for this situation as well. Clients will, again, need to agree upon how the company will be valued under such circumstances. Then, the agreement will simply state the terms under which payment must be made.
Unfortunately, insurance does not provide a payout under these circumstances. Therefore, it will be up to the other owners to fund the purchase of the ownership interest. A common means of planning for this situation would be to require a lump-sum payment due immediately with the balance to be paid in monthly payments over the next several years. This would allow the remaining owners enough time to secure funding elsewhere for the purchase price.
A business owner’s exit strategy is often overlooked when a new business is formed. A comprehensive business plan must address the exit of a business owner under different circumstances. A Buy-Sell agreement allows business owners to plan in advance for the purchase of a withdrawing owner’s interest, which prevents confusion, discord, and perhaps even a dissolution of the company.
A competent professional can assist you in drafting a Buy-Sell agreement that fits your needs. Estill & Long, LLC advises its clients to consider drafting a Buy-Sell agreement along with an Operating Agreement or Bylaws at the very start of the new company. But even if your company is already established, it’s not too late. Call us today for an initial consultation and we can draft a Buy-Sell agreement that is customized for your particular needs.
About Peter McFarland, Esq.
Peter earned his Juris Doctor (J.D.) degree at the University of Denver. After becoming licensed to practice law in the State of Colorado, he earned his Master of Laws (LL.M.) in Taxation at the University of Denver. In his current role, Peter represents taxpayers before the IRS and in the United States Tax Court. He gained valuable experience as an attorney with the University of Denver’s Low Income Tax Clinic during his graduate school studies and has been representing clients at Estill & Long, LLC since his arrival in early 2013.