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The Importance of Buy-Sell Agreements

Updated on December 2, 2013

Succession Planning

One of the most important issues for small closely held business entities is that of business continuity. This can be a concern in the face of a variety of obstacles. One of the most important areas of concern is related to a business interruption in the face of a partnership. Creating a new business entity with a partner, or even acquiring a partner within and existing business can come with a whole host of challenges. One of the first areas of concern should be addressing a proper buy-sell agreement.

Imagine owning a partnership interest with a colleague who subsequently passes away. While the two of you may have worked well together, his/her portion of the business interest ownership is likely to pass to his surviving family members, depending on the terms of their estate plan. Yet, is it prudent to now take on their spouse or children as your new partner ??? More often than not if they hadn’t been actively participating in the daily operations of the business entity, they’re not qualified to work with you on a daily basis. They will likely become an economic liability to you...the surviving owner who is now responsible for the day to day operations without the same assistance. A buy-sell agreement is a legal contract between partners which specifies the terms under which one partner or their inheriting family members would be essentially bought out of an ownership interest. These agreements are commonly funded with life insurance policies held by each partner on the life of the other. The terms of the agreement dictate the amount of coverage that needs to be in force to properly reimburse the surviving inheriting family member for the proper business valuation.

There are several potential triggering events that can cause a buy-sell agreement to activate either a mandatory or optional buyout of a business partner. One such obvious event is the death of a partner. Another such event could be a newly incurred disability of a partner. Should the partner be a unable to perform the daily functions of the their business operations, they may have a personal disability policy for themselves. While that may suffice to help reimburse them for their daily living expenses, it does little for you the alternate partner whom must now assume the greater responsibility. Holding a disability policy on your partner can be a method to fund a buyout of the disabled partner’s equity.

There are also other possible triggering events that are not as easily addressed. In some cases a partner may be forced into the unfortunate circumstance of a divorce from their marital partner. In such cases, you as a business partner are often invariably drawn into the equation. The divorcing spouse of your partner may want to continue to maintain their ownership interest in the business entity even though they had little to nothing to do with its daily operations. While this cannot be addressed by funding the agreement with a life insurance policy, it is important to have such terms and the corresponding triggering events addressed in the initial buy-sell agreement.

Retirement is also potential triggering event that should be addressed. In many cases two partners may have a substantial difference in age, or simply differing opinions on when they might like to retire. The terms of such a decision should also be carefully spelled out within the buy-sell agreement. Planning to address these issues in advance is imperative, as it allows for the proper funding of such an event in advance.

In some cases there may be multiple partners which can further complicate things. This is typically addressed by what is called a cross purchase agreement. This is fundamentally the same principle, but addresses the terms of each partner, as well as how the proper insurance is funded.

A very important component in all of these agreements is setting a proper business valuation. In some cases this is a specific fixed dollar value, and in some cases it is a formula to determine proper valuation. Some agreements may use either the book value method, discounted cash flow method, sales multiple valuation or capitalization of earnings method. What’s important is that these buy-sell agreements be addressed and updated from time to time if necessary. While the terms may have been acceptable based on the methodology at the time, the insurance coverage over time may no longer be sufficient to cover the deceased owner’s current equity. As the business grows in economic value, the amount of corresponding insurance may need to increase. This often makes term insurance policies difficult to utilize as a mechanism to fund such agreements, as they require increasing amounts of insurance to be met with updated medical examinations.

A proper succession plan is often a complicated matter, and depends on a number of factors that are specific to the dynamic of the specific business, it’s partners and their individual roles within the organization. This is an important component of a properly structured estate plan for the small business owner who is involved in a partnership. It is always advisable that business partners sit down together with an attorney who has expertise in the area of business succession planning.

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