Crafting a buy-sell agreement for your business

ARTICLE | February 10, 2023

Kelsi S. Dickerson, CPA, Tax Manager at Heard, McElroy & Vestal

Buy-sell agreements are an essential tool for businesses with more than one owner. This type of agreement determines what will happen to the departing owner's share of the business if they leave the business. By planning ahead, you can reach an agreement while all owners are on the same footing. This is important because it can be difficult to negotiate after a triggering event occurs.

What is a buy-sell agreement?

A buy-sell agreement is a contract among owners of a company that outlines how an owner's interests can be transferred to a buyer if a triggering event occurs. A triggering event may be the owner deciding to sell their interests, leaving the company, dying, or becoming incapacitated. The agreement defines how the equity interests will be valued and who will have the right to purchase the owner's shares.

This agreement typically stipulates that the departing owner will sell their shares back to the remaining owners at a price based on a predetermined formula, and it may also include provisions for how the purchase will be funded. The price is typically determined by (1) having an appraiser determine the full market value of the business, (2) a predetermined agreed-upon value, or (3) using a predetermined formula.

While a buy-sell agreement is not required by law, it is a critical tool for protecting the interests of all owners of a business. For the departing owner, a buy-sell agreement ensures they will receive fair value for their shares. For the remaining owners, it ensures they will not have to deal with the departing owner's heirs or other third parties. 

There are two main ways to structure a buy-sell agreement. Under a cross-purchase agreement, each owner agrees to buy out the other owner's share of the business in the event of their death, disability, or departure. The purchase is typically financed through a life insurance policy, a loan, or personal funds. Under an entity purchase agreement, the business agrees to buy out the other owner's share of the business in the event of their death, disability, or departure. Like a cross-purchase agreement, the purchase is typically financed through a life insurance policy, a loan, or corporate funds.

Key components of a buy-sell agreement

Trigger events are any event you want to "trigger" the terms of the buy-sell agreement. They can include retirement, incapacity, disability, death, and voluntary departure, among others. A well-crafted buy-sell agreement will consider as many "what-ifs" as possible to smooth the transition.

One of the most critical components of a buy-sell agreement is the valuation of the business and each shareholder's interest. This portion of the agreement aims to reduce conflicts between departing and remaining owners (and potentially their families) regarding their stake in the company. In this section of the agreement, it's important to devise a methodology for valuing the company in the future. For example, the owners may decide to obtain three different valuations and find the average value of the company based on the three valuations. The owners may also work with their accountants to determine a formula for valuing the company. If the owners opt for this valuation method, it is important to include language to ensure the formula does not become stale.

Once a valuation method has been determined, owners will need to consider how a payout will be financed, if at all. If the owners opt to finance a portion of the buyout, they will need to determine the length of the term and the interest rate. And given that buy-sell agreements may not come into play for years, it's wise to avoid a fixed interest rate. It is best to stipulate that interest rates follow the applicable federal rate at the time of closing.  This portion of the agreement should also reference any life insurance policies acquired to fund the buyout.

What should you consider when drafting a buy-sell agreement for your business?

While buy-sell agreements can help protect the interests of all parties involved, they can also be a source of conflict if they are not drafted correctly with clear and unambiguous language. This cannot be emphasized enough, as ambiguity or minor discrepancies can lead to conflict about the required procedures and value of the business after a triggering event. Such conflict can result in costly litigation and animosity between the parties. Business owners should consult with attorneys and accountants to ensure that the agreement's language matches their intentions.

Buy-sell agreements are not something to set and forget. They must be reviewed periodically to ensure the agreement still meets everyone's goals. Likewise, the business should be valued regularly to ensure the sufficiency of any life insurance policies that will fund a potential buyout.

The best way to ensure your buy-sell agreement is expertly crafted and suits your business's needs is to meet with experienced professionals who understand the complexities of these types of contracts.