Key Features
- Method of valuing interest. Formulas and appraisals are commonly used valuation methods.
- Triggering event. This is the event that kicks a buy-sell agreement into gear.
- Right of first refusal. Typically, if the company doesn’t buy the interest, then it can be purchased by (an)other owner(s).
- Funding mechanism. Payment for the buyout might be permitted to come in installments, for example, or from life insurance payouts.
- Transfer restrictions. The sale of an interest to an outside actor is usually restricted until a series of actions has been taken.
- Spousal consent. In some states, a buy-sell agreement requires owners’ spouses to sign that they consent to its terms.
When to Use a Buy-Sell Agreement
A buy-sell agreement can hedge against fallout when something unexpected happens. Say you go into business with a partner, and then the partner dies, bequeathing her shares of company stock to an adult child. A buy-sell agreement would force the sale of those shares so you’re not suddenly doing business with someone you didn’t intend to do business with.
This is distinct from a buyout agreement, which is effective upon signing and typically used after someone decides to exit an arrangement. Anyone going into business with another person or people is strongly advised to draft, agree on, and sign a buy-sell agreement.
What’s a Triggering Event?
A triggering event kicks a buy-sell agreement into effect. Triggering events include:
- Death of a co-owner
- Permanent disability of a co-owner
- Co-owner’s retirement
- Divorce
- Bankruptcy
- Breach of a governing agreement
- Attempted transfer to a third party
- Deadlock among business owners
- Loss of a professional license
Define Disability
Agreements should carefully define disability. Typically, buy-sell agreements consider how a disability affects an owner’s role, how long this disability has to last before it’s considered permanent, and whether a physician verifies the disability.
Types of Buy-Sell Arrangements
- Cross-purchase. Remaining owner(s) buy(s) a departing owner’s interest.
- Entity purchase agreement. The business itself purchases the departing owner’s interest.
- Hybrid arrangement. The company has an opportunity to purchase the interest, and then (a) remaining owner(s) can purchase what’s left.
Methods of Valuing an Interest
Because a buy-sell agreement goes into effect at a later date, it’s difficult to know the precise value of an owner’s interest. Agreements usually deal with this uncertainty in one of the following ways:
- By setting a stipulated value, or a dollar amount for one share or unit of ownership.
- By setting a fixed value, or a dollar amount for 1% of ownership of the company.
- By agreeing on a formula (for example, a multiple of average annual net earnings over the preceding two years).
- By committing to source an independent appraisal some number of days after the occurrence of a triggering event.
FAQ
Can life insurance fund a buy-sell agreement?
Yes. Business owners can take out life insurance policies to fund the later buyout of their shares. What this means, in essence, is that each business owner or the business itself has a policy for another owner’s life. If someone dies, then insurance covers the cost of purchasing their shares.
What’s a disability buy-sell?
This is a buy-sell agreement that sets the stage for a buyout when a co-owner of a business becomes permanently disabled.
How does a buy-sell agreement work in real estate?
Often, co-owners of a property will sign a buy-sell agreement that dictates what happens if a co-owner wants to sell their ownership percentage, dies, or otherwise can’t make payments.