When a business owner dies or leaves a company unexpectedly, disagreements among the remaining owners and outside parties, such as a deceased owner’s heirs, pose a threat to its financial health and continued existence. A buy-sell agreement can help mitigate such risk.
What does it do?
A buy-sell agreement is a legal document that gives parties the right or obligation to buy shares when a “triggering event” occurs. These events include an owner’s death, disability, divorce, termination of employment or withdrawal from the business.
Properly structured, the agreement limits ownership and control of the business to a select group such as co-owners, family members or members of management. This helps prevent the company from falling into the “wrong” hands — for example, those of an owner’s creditors or former spouse.
How is it valued?
Buy-sell agreements essentially help create markets for what might otherwise be unmarketable assets. Unfortunately, the value of shares in a privately owned company isn’t as immediately apparent as it is with publicly traded shares. So a buy-sell agreement needs to specify the value of ownership interests — or provide a methodology for calculating value when a triggering event occurs.
To help ensure such values will hold up to any legal challenges, engage a professional business valuator to make an initial appraisal, as well as periodic re-appraisals of your company. You want the agreement’s pricing terms to be as precise and unambiguous as possible so they aren’t misinterpreted later on.
How is it funded?
One important role of many buy-sell agreements is to provide liquidity so that a departing owner’s business partners can afford to buy back shares. To make such liquidity possible, you’ll need to “fund” your buy-sell agreement. If your company is cash-rich and confident in its ability to remain so, you could use reserves. However, life insurance generally is a more accessible and less risky solution for funding a buy-sell agreement.
In addition to providing liquidity for remaining owners, life insurance proceeds can help a deceased owner’s heirs pay estate taxes. The value of a life insurance policy also might provide liquidity for an owner who retires or becomes disabled.
These are only the most common uses of buy-sell agreements. Talk with your financial advisor about how an agreement can help prevent ownership and control disputes, protect against partners’ fraudulent or inappropriate behavior, and even establish a value of your business interests for gift and estate tax purposes.