The Buy-Sell Agreement: An Essential Tool for Jointly-Owned Small Businesses

One of the most common scenarios in business is for the owners part ways. This can occur under a variety of circumstances, ranging from disagreement over the continued management and direction of the business, to incapacity or death. Due to a lack of planning, this transition is rarely smooth.

Fortunately, a contingency plan can be created in advance by using what is known as a "Buy-Sell agreement". A well-planned and well-drafted Buy-Sell agreement is an excellent tool for business owners who seek to avoid disruption of a business upon the departure of one or more of its owners.

A Buy-Sell agreement is useful regardless of the entity form being used (LLC, corporation, etc.), and can be flexibly structured to meet a business's needs.

Most Buy-Sell agreements restrict the sale of an owner's business interest to an outsider. In a "cross-purchase" arrangement, the remaining business owners may be required to purchase the departing owner's interest for a fixed price, or for a price to be determined based on an appraisal or stated valuation formula. Purchase payments may be made in one lump sum, or may be structured over time.

As an alternative to a mandatory purchase arrangement, business owners may choose to utilize either a purchase option or a right of first refusal. A purchase (or "buy-out") option gives the remaining owners the option to purchase the departing owner's interest for a predetermined sum. A right of first refusal, on the other hand, gives the remaining owners the right to beat any third party's purchase offer.

A "stock redemption agreement" (also known as an "entity-purchase agreement") is another common form of a Buy-Sell agreement. In this type of agreement, the entity itself purchases the ownership interest of the departing owner. This type of Buy-Sell agreement is well suited for businesses with many owners.

Regardless of whether a cross-purchase, entity-purchase, or a hybrid of the two is used, cash will invariably be needed to purchase the departing owner's interest. Life insurance is commonly used for this purpose, but for obvious reasons is only available in the event of the death of an owner.

When using a stock redemption agreement, a business may choose to fund the buy-out with accumulated earnings and corporate profits. If this type of arrangement is utilized, care should be taken to avoid any unecessary and unexpected tax consequences.

Ultimately, business relationships really are much like romantic relationships. They require a lot of skill and a lot of effort to succeed. Even if the owners are on the best of terms, an unexpected death can really leave a business in a lurch. In the absense of a Buy-Sell agreement, the decedent's estate (i.e. spouse or children) will take over his or her ownership interest. Generally, the decedent's heirs lack the skills or the temper necessary to competently assume the decededent's ownership responsibilities. By using a Buy-Sell agreement, existing owners can effectively maintain valuable control over who they will be doing business with in the future. Of course, the Buy-Sell agreement also works to the benefit of the decedent's heirs, in that they will receive the purchase monies due upon the transfer of the decedent's ownership interest.

These are just a few of the many reasons I strongly encourage anyone who owns a business with others to consider the use of a Buy-Sell agreement. If you would like more information related to Buy-Sell agreements or other small business issues, please feel free to contact us.