Buy-sell agreements and what they prevent

A business with multiple owners and no buy-sell agreement is one death, divorce or falling-out away from a serious problem.

What it does

A buy-sell agreement is a contract among owners governing what happens to an ownership interest on defined events.

It typically covers death, disability, retirement, voluntary departure, bankruptcy, divorce and expulsion.

For each, it establishes whether a sale is mandatory or optional, who may buy, at what price, and on what payment terms.

What happens without one

On death, the interest passes to the deceased owner's heirs.

The surviving owners find themselves in business with a spouse or adult children who may have no knowledge of the business, no interest in it, and an immediate desire for money.

The heirs, equally, hold an illiquid interest in a business they cannot control and cannot sell.

Both sides are worse off than under any agreement.

On divorce, an ownership interest may be a marital asset subject to division, potentially bringing a former spouse into the ownership structure.

On a falling-out, there is no mechanism for one owner to exit, which frequently results in deadlock and litigation.

The structures

Cross-purchase, in which the remaining owners buy the departing owner's interest personally.

This gives the purchasers an increased cost basis in the acquired interest, which is advantageous later.

It becomes cumbersome with more than a few owners, particularly where insurance funding requires each owner to hold a policy on each other owner.

Entity purchase, in which the business itself redeems the interest.

Simpler administratively, with only one policy per owner required for funding, and it does not produce the same basis increase for the remaining owners.

Hybrid arrangements, giving the entity a first option and the owners a secondary one, which preserves flexibility.

Valuation

The provision most likely to cause a dispute if drafted poorly.

A fixed price, which is simple and becomes stale almost immediately unless updated. Agreements with a price set fifteen years ago are common and useless.

A formula, such as a multiple of earnings, which is objective and may not reflect changed circumstances.

Appraisal, conducted at the time by an independent valuer under a defined procedure.

The most defensible and the slowest and most expensive.

Whichever method is chosen, the agreement should specify who appraises, how disagreements are resolved, and the valuation date.

A common and workable approach is a formula with a requirement to review the resulting figure annually and record agreement.

Funding

The part most often neglected, and an unfunded obligation is not much better than none.

Life insurance is the standard mechanism for the death trigger. Proceeds arrive when needed and are generally received income tax free.

Policy ownership should match the agreement structure, and there are technical points — including transfer-for-value rules and, for corporations, the potential effect of proceeds on valuation — that warrant professional input.

Disability insurance for the disability trigger, which is more likely than death during working years and is routinely omitted.

Instalment payments from business cash flow, which requires the business to be able to sustain them alongside operations.

Sinking funds or borrowing, both of which have limitations at the moment they are needed.

Other provisions worth including

Restrictions on transferring interests to outsiders, with rights of first refusal.

What constitutes disability, and who determines it.

Confidentiality and non-competition obligations for departing owners.

A deadlock resolution mechanism.

Provisions addressing what happens if the business cannot fund a required purchase.

Keeping it current

An agreement drafted at formation and never revisited is generally inadequate by the time it is needed.

Reviewing it whenever ownership changes, when the business value changes materially, when the tax rules change, and at least every few years, keeps it functional.

It must also be coordinated with each owner's estate plan, since a will disposing of an interest inconsistently with the agreement produces exactly the dispute the agreement was meant to prevent.

General information only, not legal, tax or insurance advice. Consult a qualified attorney and tax professional about your own circumstances.