Buy-Sell Agreements: A Must-Have for Business Owners

By Rich Gunn, BPM Partner

Operating a business with co-owners without an effective buy-sell agreement in place is like driving down the highway in a car with no brakes. When traffic is flowing smoothly, you don’t even think about them. But when traffic comes to a screeching halt, you want to know that your brakes are in place and fully effective. In the same way that your car needs an excellent set of brakes, your business needs an effective buy-sell agreement. You will eventually need it, and with life’s uncertainties and sudden surprises, you may need it sooner than you think.

If an effective buy-sell agreement is in place, co-owners of a business can exit the company, sell their shares, and successfully retire in a calm and predictable manner while allowing for the successful continuation of their business. Without that agreement, a sudden and unexpected exit of an owner can leave partners and family with significant problems, including business interruption, shareholder disputes, conflicts with heirs, significant risk to the continuation of the business, placing the value of the business in jeopardy, estate tax problems, income tax problems, and placing loved ones at greater financial risk.

Getting Started
Though there are sources that provide boilerplate buy-sell agreements, the do-it-yourself approach is NOT advised. That is just as reckless and dangerous as not having a buy-sell agreement in place at all; your buy-sell agreement has to serve the unique needs of you, your business, your partners, and your loved ones. Instead, you should consult with your CPA and other trusted advisors, who can guide you and your partners through the decisions that need to be made. The actual document should be written by an experienced business attorney based on your instructions.

Make notes about the items discussed below and bring them to a meeting with your trusted advisors. This is the first step to getting an effective buy-sell agreement in place.

Keys to Successful Planning
In my experience, here are the top considerations for successful planning.

Protecting yourself from becoming co-owners with any unwelcome partners.
Would you like to control to whom an exiting partner can and cannot transfer ownership interest to when they die or exit for other reasons? Does your partner’s will leave their share of the business to a spouse, child, or siblings and do you want to run the business with these people? Are they even qualified to run the business with you?

In a recent example, a client of mine was diagnosed with an unexpected medical emergency. The result was permanent disability, and he was told that he would not likely live another 24 months. His business partner was worried that his partner’s share of the business would be left to his wife, who knew nothing about how to run their business. Fortunately, they had a buy-sell agreement in place, which specified what was to happen when an owner because physically or mentally disabled. Specifically, the disabled partner was required to sell his shares back to the company, and could not leave his share to his heirs.

Determining how much an exiting partner will receive.
Do you have an agreed-upon valuation method for buying out partners? In my client’s case, their agreement provided a formula for determining the value of the business so that no negotiation of price had to take place. This prevented potential arguments and disputes with each other and each others’ heirs. The exiting partner’s shares were valued at $1.3 million.

Protecting yourself in the event of an unexpected death, disability, divorce or bankruptcy of one of your co-owners.
Remember that the oldest partner is often NOT the first one to retire, so don’t assume that your younger partners will be buying you out first. Death, disability, and other catastrophic events can strike anyone, at any time. In my example, the partner who had been diagnosed with the disability was actually younger than his partner and further away from retirement. In the event that you suddenly have to buy out your afflicted partners (or their heirs), you should know where the funds will come from.

Determining how the purchase price of a retiring owner will be funded.
This could be a huge drain on the cash flow of the business or the remaining partners’ personal finances, if not well-planned. Will partners buy each others’ shares or will the business? Where will the funds come from? If the business buys the shares, will they be paid for out of operating income, reserves, or insurance proceeds? Are there the right types of life insurance and disability policies in place to fund unexpected buy out situations? How often are these policies reviewed so that their benefits keep pace with the changing value of the business?

My clients’ buy-sell agreement had required the company to carry disability insurance on each of the owners so that the company could buy back the shares with the insurance proceeds. As a result, the remaining partner did not have to come out of pocket with any money to buy his partner’s shares at their current value. The disability proceeds came out to $1.3 million, sufficient for the exiting partner’s family to pay the rest of their mortgage and put aside money for their daughter’s college fund.

If you already have a buy-sell agreement...
Don’t let an agreement sit on your shelf collecting dust. Review it with your trusted business advisor at least annually. Make certain that all of the components are in sync with business operations, retirement plans, funding strategies, and the economic realities of the business and each of its owners.

Don’t put your business at risk, and don’t put your family’s finances in jeopardy.
If you don’t have an effective buy-sell agreement in place, you should make this a very high priority in your business plans. You and your loved ones, as well as your partners, will be well protected if you get this done now. The continuity of your business, after the departure of current owners, is much more likely to happen with continued success when you have an effective plan in place.

This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.