What Is a Buy-Sell Agreement? A Simple Guide for Small Businesses

When starting a small business, you may not be thinking about what happens when your business days are over. But having a good succession plan is vital. Statistics show that about 20 percent of new businesses fail within the first year, 45 within the first five, and 65 businesses close in the first 10 years. Those numbers are higher for partnerships, with 70 percent of business partnerships going under.

Life – and business – can be unpredictable. You need to be ready for anything. That is where buy-sell agreements enter the picture.

What is a buy-sell agreement?

A buy-sell agreement is a legally-binding document that indicates what will happen to an owner’s share in the business if they pass away, retire, move on or any other number of scenarios occur. They are key to a solid succession plan. The goal is to smooth any transitions that may happen if an owner leaves for any reason.

Buy-sell agreements are also called buyout agreements, business will or business prenup. They need to be drawn up by a lawyer because they are legal documents. The terms often indicate how the shares need to be sold to the remaining partner. There may even be a predetermined formula in the agreement that stipulates the prices paid for the shares.
However, if the owner passes away, their estate must agree to the sale.

Benefit of buy-sell agreements

There are a number of good reasons to have a buy-sell agreement put in place for your business, such as:

  • Ensure company continuity
  • Protect business ownership
  • Reduce the chance of dispute between partners
  • Protects the assets of a business
  • Peace of mind for owners
  • Defines fair value for shares
  • Clearly defines exit plan for owners

Remember that your partner’s personal life can also impact your business. For example, if they were to get a divorce, you’ll want to protect the company. For that reason, small businesses should seek the services and advice of a financial planner.

Types of buy-sell agreements

There are two popular types of buy-sell agreements:

  1. Cross-purchase – this type of buy-sell agreement allows other owners to buy a partner’s interest if a triggering event has occurred.
  2. Redemption agreement – here, the agreement allows the business to purchase the departing partner’s interest.

Some buy-sell agreements use a mix of the two types and allow some portions of the shares to be bought by individuals and the rest by the business. There are hybrid buy-sell agreements that are also known as wait-and-see agreements. They offer some flexibility for remaining business partners by allowing a company to decide the details of the buyout after a triggering event occurs.

Who uses buy-sell agreements?

Buy-sell agreements are most often used by sole proprietorships, partnerships and closed corporations. However, they could be used by any entity as a form of protection. Some businesses that may want to consider drawing up a buy-sell agreement include:

  • Law firms
  • Medical offices
  • Mechanics
  • Mental health offices
  • Retailers
  • Landscape businesses
  • Restaurants

Remember that buy-sell agreements are designed to protect the business and the partners in case of a disruption to ownership. Therefore, any partnership can benefit from having a buy-sell agreement in place. It can give business owners and partners peace of mind knowing their hard work will not be wasted if something unpredictable should happen.

Things to consider about buy-sell agreements

Buy-sell agreements are usually drawn up to protect the business and the partners when there is a disruption in ownership. For example, the agreement can prevent an owner who is leaving the business from selling their shares to an external party without the approval of the other partners. In this way, it can keep the integrity of the business intact.

You may also want to seek the help of a wealth management advisor to protect your business or personal finances. They can help you understand what you need in a buy-sell agreement. Wealth management advisors also help you ensure you have enough when it comes time for you to leave the business.

These agreements are also helpful in that they lay out a method for determining the value of the shares. This calculation can be used in other business areas, such as in a dispute among owners about the value of their shares.

Buy-sell agreements should include the following:

  • List the parties involved in the agreement
  • Define trigger buyout scenarios
  • Detail a buy-sell valuation method
  • List the company valuation
  • Any funding resources
  • Consider how taxes can impact the agreement

Avoid common buy-sell agreement mistakes

It’s crucial to keep in mind that buy-sell agreements are legal documents. That means they are binding, and there is a process you need to follow when having them developed. Always be sure to use the services of a trusted attorney when working out the details of a buy-sell agreement. Also, be honest and straightforward with your partners and encourage good communication about the agreement’s details.

If you follow these steps, you should be able to avoid these common mistakes:

  • Failure to organize details with partners
  • Not choosing the correct agreement
  • Using an incorrect valuation method
  • Failing to identify all the triggering events, you need to
  • Avoiding discussing funding issues
  • Not establishing financing terms in the agreement
  • Failing to include business real estate in the plan

Buy-sell agreement protection

When you are just getting started in a business, it’s easy to get caught up in the excitement and think that you’ll be working together for a long time. But this isn’t always the way it plays out. Many unpredictable things can happen that threaten the future of the company. If one of your partners dies or becomes disabled, you’ll need to have a plan in place that fairly deals with the partner’s shares.

In other situations, one business owner may decide to retire, there could be a dispute between the partners, and one may want to leave. Any number of possible scenarios could put your business at risk. Having a buy-sell agreement protects you and your company in the face of adverse circumstances.

If you want to protect your business or personal assets, our team at IronOak can help. Contact us today and begin your journey to a robust financial future.

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