Do you know what would happen to your business if your partner got recruited for an amazing job from Google and took it?
What about if you have a snowboarding accident and are unable to work?
What if one of your partners is arrested and sent to prison?
If your partner and her spouse co-own their share of the business, what happens to the share if they divorce?
When you are launching a new business, these types of questions are ones you don’t want to even think about much less talk about with your partner or partners. But as you plan and execute all the tasks that go along with starting a new business, don’t neglect one of the most important documents to ensure the smooth running of your business in the future. That document is a Buy-Sell Agreement.
What is a Buy-Sell Agreement?
Just as a Pre-nuptial Agreement, or Pre-nup, helps married couples determine in advance what happens to their assets in the event of a divorce, a Buy-Sell Agreement is a legal contract between multiple owners of a business. The contract provides for the future sale of your business interest or for your purchase of a partner’s interest in your business. Buy-Sell Agreements, also known as buyout agreements or as business continuation agreements, create rules for an orderly transition when an owner needs or wants to transfer his or her interest in the company or when a business owner ceases to be an owner for any reason.
Your agreement, which can be customized for your particular business and for your partnership’s needs, can either be a section of your company’s operating agreement or a separate document. Typical triggers that would put the provisions of a Buy-Sell Agreement into action are:
- loss of interest
- loss of a professional license
Importance of A Buy-Sell Agreement
Let’s look at why a Buy-Sell Agreement is important. Let’s say you and your business partner, Ryan, are co-owners of your company. You have formed it legally, you have bylaws in place, and you both understand the tax laws governing your small business. Everything is going smoothly until Ryan gets divorced and files for bankruptcy. What happens to Ryan’s half of the business? Does it go to his wife? Or do you own Ryan’s share now? How much is his share worth? Will it go to Ryan’s creditors? Will your company be in trouble now?
If you have a Buy-Sell Agreement in place, you will have a previously agreed-upon plan to follow that will protect your livelihood in unpleasant situations such as this one.
Let’s consider another scenario. You own your business equally with two other partners. If one of your partners dies unexpectedly, you and your surviving partner might assume you could purchase the deceased partner’s share of the company and continue operating your business as usual. However, unless you have a Buy-Sell Agreement, it is common for the partner’s share of the company to be included in his or her estate. You could easily get involved in a complicated – and costly — legal battle with your deceased partner’s beneficiaries.
Funding a Buy-Sell Agreement
Let’s say you are able to avoid complications with an estate, and your partner’s widow agrees to sell her husband’s share to you. How will you and your other partner afford to purchase the third share? This is another example of how a Buy-Sell Agreement can help.
Many insurance companies offer policies that cover Buy-Sell Agreements in the event of a business partner’s death. If you and your partners each have a life insurance policy with a Buy-Sell Agreement as part of it, you will each be assured you will have the funds to buy your partner’s share and to keep your business running smoothly.
While sad events are often the reason a Buy-Sell Agreement is needed, you may find the document useful in the event you or your partners’ career or life plans change. Some business owners get bored and want out of a business arrangement. Some partners want to retire earlier than expected. A Buy-Sell Agreement can be a safety net for the remaining partners so that the business can keep operating as it was before this new development.
Setting up a Buy-Sell Agreement
One type of Buy-Sell Agreement is a cross-purchase agreement. With this arrangement, if you or Ryan dies, becomes disabled or goes bankrupt, you can buy each other’s share. Another option is a redemption style agreement. This arrangement is set up so that the business itself would make the purchase of the partner’s share, not the individual partner.
With either type of agreement, you can work in some flexibility that will work for your small business. For example, you might want the purchase price to be fixed, or you might want it to be determined by an appraisal or some other formula specific to your industry. You can determine in advance if the purchase price should be paid in cash or in installments.
You can even add in different terms for different scenarios: one payment plan for a disability and another payment plan for a retirement, for example.
While we have looked at scenarios when a Buy-Sell Agreement is important with a few partners, the stakes are higher the more partners you have. What if you are one of a dozen owners of your business? The likelihood that there will be one of the Buy-Sell trigger situations or some other dispute of ownership is all the greater, and so is the need for the document.
Discuss the benefits of a Buy-Sell Agreement with your business partners and then make an appointment with your attorney to set one up. It’s a good idea to also consult your accountant and your insurance agent before you finalize the agreement.
In the midst of all the decisions you are making to launch your business, you’ll find that a Buy-Sell Agreement is one that will save you money and will offer you valuable peace of mind down the road.
Tricia Drevets is a staff writer for Fit Small Business, a publication that aims to help small businesses grow their top and bottom lines. In Fit Small Business, you will find guides on topics like how to get an SBA Loan and buying advice on purchasing services such a business VoIP.