Buy-Sell Agreements: What They Are & How They Work

What are Buy-Sell Agreements

Buy-sell agreements, also known as buyout agreements, are legally binding contracts between business co-owners that detail the procedure for the purchase or sale of departing owners’ shares. These agreements come into play in several scenarios, such as retirement, bankruptcy, divorce, disability, or death of an owner. The primary purpose is to ensure that the business continues to operate smoothly, preventing independent third parties from acquiring ownership and providing financial assurance to the remaining owners that transitions can be handled smoothly.

Structured properly, buy-sell agreements dictate who can buy an exiting owner’s share of the business and under what conditions. The agreement typically outlines a predetermined price or valuation method for the owner’s share, thereby reducing potential disagreements on business value. It’s like a prenuptial agreement for business partners, providing a roadmap for handling potentially difficult situations.

How Buy-Sell Agreements Work

Buy-sell agreements work by first identifying key triggering events. These triggers are circumstances under which an owner’s share of the business would be bought out, such as retirement, bankruptcy, divorce, disability, or death. Once a triggering event occurs, the agreement governs how the buyout process will proceed. 

Buy-sell agreements also typically outline prices at which shares should be traded. The agreement should specify either a fixed price or a formula to calculate the price at the time of the buyout. There are different ways to value shares, including based on book value, discounted cash flow, or a standard industry multiple. The agreement can also outline how the price must be paid – either as a lump sum or in installments. The funding for the buyout often comes from the company’s revenue, personal funds, or a life insurance policy taken on the owners.

How to Fund a Buy-Sell Agreement 

Funding a buy-sell agreement is critical to the successful execution of the contract. The funding mechanism chosen determines how quickly the buyout proceeds can be available to the departing owner and what financial burden, if any, will be placed on the remaining owners or the business. 

Below are some common methods of funding a buy-sell agreement, each with benefits and drawbacks.

• Personal savings: The most straightforward way to fund a buyout is for the remaining owners to use their personal savings. Owners must regularly set aside funds for potential buyouts. While this strategy can be feasible for small businesses with minimal ownership changes, it can become difficult as the business or the number of partners grows.
• Installment payments: In this case, the buyout is funded over time, with the remaining owners making payments to the departing owner or their estate. This arrangement can ease the immediate financial burden on the business or remaining owners. However, it also impacts the cash flow over some time. It could also cause financial strain if the business faces a downturn or if multiple triggering events occur in a short period.
• Borrowing: Another option is to fund the buyout through debt, such as a business loan or line of credit. This method provides immediate payout to the departing owner. However, it can burden the business with debt and interest payments. And, depending on the age and type of business, it may not be an option.
• Life insurance or disability insurance: Often, co-owners of a business will take out life insurance or disability insurance policies on each other to fund buy-sell agreements. If a triggering event is the death or disability of an owner, the business can use the policy payout to fund the buyout. This method provides a lump sum payment without impacting the business’s cash flow or incurring debt. However, premiums for such policies could be high for older owners or those in poor health.
• Sinking fund: A sinking fund is a pool of money that a business sets aside over time specifically to fund future buyout events. These funds are typically invested, allowing them to grow until needed. While this method requires saving, it spreads the responsibility across the business rather than individual owners. 

Each of these funding methods has its advantages and disadvantages, and what works best will depend on the business’s specific circumstances and its owners. If you aren’t sure which one is right for you, consult with financial advisors or legal experts when your buy-sell agreement.

Why Life Insurance is Used for Buy-Sell Agreements

Life insurance is a preferred choice for funding Buy-Sell agreements for several reasons. First and foremost, it guarantees immediate liquidity upon the death of an owner. The death benefit from the life insurance policy can be quickly accessed and used to buy out the deceased owner’s share without financial strain. This avoids the need for the remaining business owners to search for external financing at a critical time.

Secondly, life insurance provides a predefined and known cost for the buyout. When setting up the policy, the owners can determine the exact death benefit amount and premiums to be paid each month. This predefined cost reduces the risk of business owners failing to set aside money themselves to use if a triggering event occurs.

Lastly, using life insurance to fund a buyout agreement can offer tax benefits. Death benefits received from life insurance policies are generally tax-free. This means the remaining business owners can use the entire policy amount to buy out the deceased owner’s share without being burdened by taxes. Furthermore, the premiums paid for the life insurance policies can sometimes be deducted as a business expense. 

However, tax rules can vary, and it’s advisable to consult with a tax professional to understand all the implications.

Common Mistakes Made in Buy-Sell Agreements

While buy-sell agreements can be a powerful tool for business continuity and transition, they have potential pitfalls. Mistakes in drafting, funding, or implementing these agreements can lead to significant challenges, including financial strain, legal disputes, and even business failure. 

Here are some common mistakes to avoid:

• Not having a buy-sell agreement in place: Perhaps the most glaring mistake is not having a buy-sell agreement in place. Without this agreement, businesses are vulnerable to a range of uncertainties, including who can buy an outgoing owner’s share, the shares’ value, and the buyout terms.
• Inadequate funding: If the funding mechanism, such as a life insurance policy, is insufficient to cover the value of the owner’s business interest, it can lead to financial strain for the remaining owners and the business. If funding a buy-sell agreement with a life insurance policy, ensure it is large enough to cover it.
• Not naming the right policy owner and beneficiaries: In a life insurance-based buy-sell agreement, the policy owner and beneficiaries play a crucial role. It’s vital to select the right owner of the policy to ensure that it remains in effect even if an owner leaves or there are changes in the ownership structure. When you set up the policies, work with your attorney and insurance company to make sure policies have the right owners and beneficiaries.
• Failure to regularly review and update the agreement: Business circumstances and valuations can change over time. If the buyout agreement is not regularly reviewed and updated, it can lead to disputes and potential litigation.
• Lack of clarity in terms: A buy-sell agreement should be clear and specific. Vague or ambiguous terms can give rise to differing interpretations, leading to disputes among the owners.
• Ignoring tax implications: The tax implications of these agreements can be complex and have a significant financial impact on the business and the owners. Failing to consider these implications and plan accordingly can lead to unexpected tax liabilities.
• Failing to involve professionals: Drafting a buy-sell agreement involves a combination of business, legal, and financial considerations. The process can be complex and may require professional expertise. Failure to engage professionals, such as attorneys or tax advisors, during the drafting process can lead to costly mistakes.