Buy-sell agreements are among the most common yet least understood business agreements.
They are agreements between the owners and the company, and many are destined to fail to operate like the owners expect when they need them. Many, in fact, are ticking time bombs, just waiting for a trigger event to explode.
Buy-sell agreements are ownership transition plans in disguise. Some agreements create unintended consequences, while others have become obsolete because of changes in the business, personal life or other circumstances.
If you own all or part of a business – any business – you should know about buy-sell agreements.
Unless you plan to be lucky forever, you'd better have one. Without it, a closely held or family business faces a world of financial and tax problems on an owner's death, incapacitation, divorce, disagreement with other shareholders, bankruptcy, sale, retirement or voluntary departure prior to retirement.
The cost of a buy-sell is tiny compared to its benefits. A buy-sell agreement can ward off infighting by family members, co-owners and spouses and keep the business afloat so its goodwill and customer base remain intact, and avoid liquidity problems that often arise on these major events.
A buy-sell agreement makes sense for any business entity, including corporations, partnerships, limited liability companies and even proprietorships. These agreements are extremely important to protect your wealth and ensure your family is financially protected upon your departure, voluntary or involuntary.
An example: You and Joe run a hot dog stand as 50-50 partners. You might have a written agreement or a mere handshake.
Do you still have a business? Is Joe's wife or child your new partner?
Do you have the right or the obligation to buy them out? If so, for how much and on what terms?
Can you strike out on your own with your own hot dog stand, or are you stuck with the baggage of the old one? What if you die instead of Joe?
As the example shows, the most basic business can benefit from a buy-sell, even if it's the business' only written document.
Disputes and confusion can result without one, even in a small business, and the stakes go up with larger and more complex businesses.
You can have a buy-sell agreement with two owners or with many. Suppose you have 10 owners in a family company and someone tries to transfer their shares to a competitor?
Such events are easy to prevent with a buy-sell but very expensive otherwise.
One type of agreement is a cross-purchase: If you or Joe dies, becomes disabled, goes bankrupt, etc., the other can buy his share. For multiple owners, there are hybrid cross-purchase agreements that address the complexity of multiple shareholders.
The second type of agreement is redemption style, when the business itself would make the purchase so the owners don't individually go out of pocket.
With either type of buy-sell, there's a lot of flexibility. The price might be fixed, determined by appraisal or formula. The price might be paid in cash or installments over time.
There can be different terms for different events – one price and terms for retirement, one for disability and one for death, for example.
Insurance features prominently in many buy-sell agreements. You don't have to use insurance, but it can ensure there's cash available when the time comes.
For example, whether you or Joe dies first, a life insurance policy on each of you can fund the buyout so your hot dog stand stays afloat and so spouse/heirs are bought out as agreed.
Some clients find it difficult to face these issues and to make some of the myriad decisions.
One of the beauties of the process is that buy-sell agreements are reciprocal. No one knows for sure if you or Joe will be the first to go by death, disability, retirement, etc.
That reciprocal nature makes negotiating and agreeing on these issues easier than you might think.
You'll need a business or tax lawyer experienced in buy-sell agreements to help you choose the right type and draft it.
But these agreements can be surprisingly simple and not that costly. Whatever you spend on a buy-sell, it will be a drop in the bucket compared to what it can save you.
Finally, your agreement should be reviewed at least every two years and the valuation calculation completed annually.
Life changes. Business changes. People change.
Keep everyone on the same page, and make changes in the agreement to reflect changes in the business and your personal lives. Don't let the ticking time bomb go off.
Tom Garrity is managing partner of Compass Point Consulting LLC in Bethlehem. He is a certified coach with Gazelles International and a certified exit planning adviser with the Exit Planning Institute. Compass Point provides growth and business transition consulting to small- and medium-sized businesses. He can be reached at 610-336-0514 or firstname.lastname@example.org.