Buy-sell agreements can alleviate disputes that can arise between or among owners and can provide for payments to buy out an owner’s interest in the business at an owner’s death or disability without disrupting the ongoing business. It can avoid family fights, fights between surviving owners and the deceased owner’s spouse, while maintaining the integrity of the company’s goodwill and liquidity. They are an essential part of proper corporate governance for any closely held business. If an owner is unable to continue in the business, the agreement triggers the sale of that owner’s portion of the company at a price designated in the agreement.
A buy-sell agreement is essential no matter what type of business you own.
Whether you have a partnership, an LLC, a joint venture, or a corporation, a buy-sell agreement will help to avoid possible heartache, lawsuits, and financial ruin. Think about the alternative. If you have three owners of a business and the owner named John dies, is disabled, files for bankruptcy protection, or gets divorced, what happens to John’s ownership in the business? If John dies, his heirs will now control John’s ownership in your business. That means John’s wife, 19 year old son, or great uncle could now own a third of your business. As much as you may like them as people, they may know nothing about your business. Do you want them as an equal owner as you in your business?
If John is disabled and you have not provided for a buy/sell event, you have lost John’s productivity, but your operating agreement may still require that he is paid 1/3 of the profits. How fair is that to you? If John files for bankruptcy protection, the bankruptcy trustee will sell John’s interest to whoever will pay him the most money for it. Then you will be stuck with a new equal owner you don’t even know (much less get along with). If John, your friend, gets divorced, you could suddenly be faced with the real possibility that John’s ex-wife may own 1/3 of your company.
Among other contingencies, a buy-sell agreement should cover whether an owner is required to sell his interest to the company in the case of:
- Change of relationship between owners
- Attempt by one owner to Sell his or her ownership in the company to a third party
- Deadlock (equal owners cannot agree about the direction of the business)
- Default of one owner in financial obligation
“Funding” a Buy-Sell Agreement
Once you have determined that these events (and others) trigger the sale of one owner’s interest in the company back to the company, how does the company pay for that purchase without shutting its doors? What will the sales price be? These are very important considerations. The value of the ownership interest could be set artificially low in order to owners to sell their memberships, as long as all understand it would also limit the recovery of the owners’ heirs upon death or disability. How to come to a true value can be more problematic. Each owner will want to be paid his or her fair value, while nobody wants to overpay someone else for their interest. Periodic or triggered upon sale appraisals may be a viable option for determining fair value.
A well-designed buy-sell agreement will be “funded” with life and/or disability insurance. The company pays the premiums on a policy insuring the life of the owner, with the company as the beneficiary of the policy. In this way, the company’s on-going income stream is funding the buyout, keeping the company from having to borrow or take important revenue reserves to buy out a deceased or disabled owner’s interest. Further, in the case of death, we recommend that companies over insure on the life of other owners. The reason is that it will certainly be difficult for the company to replace that owner’s productivity, rain making ability, or other expertise, so the company may well lose money while trying to replace that owner. Overfunding the policy by as much as three times the buyout value is sometimes in order in order to fully protect the company.