Buy-Sell Agreements & The Five Provisions Every Agreement Should Include

A well-drafted buy-sell agreement is a crucial document for any business with multiple owners. It's essentially a business prenuptial agreement and outlines what will happen to ownership shares when a partner exits the business, whether voluntarily or involuntarily, among other things. Without a strong and comprehensive buy-sell agreement, owners risk disputes, financial hardship, and even the dissolution of their business. 

Business owners should always hire an experienced business attorney to draft their buy-sell agreement and the agreement should be tailored to their business’ specific circumstances and the owners’ needs. It’s also a good idea to involve a trusted and seasoned financial advisor and CPA in the drafting because these professionals can help owners address investment and tax considerations.  

Here are the five essential provisions that should be a part of every buy-sell agreement: 

1. A definition of the triggering events

A buy-sell agreement should define the specific circumstances – the triggering events -- that will activate the agreement. Common events include:

• Death. The death of a partner is the most common triggering event. The agreement should outline the process for transferring ownership when this happen.
• Disability. A partner’s long-term disability can significantly impact their ability to contribute to a business and can have serious implications for its operations. Therefore, every buy-sell agreement should describe the buy-out process in such a situation.
• Retirement or Withdrawal. Partners may want to sell their shares in their business either because they have reached retirement age or because they no longer want to be part of the business for some other reason. Therefore, to ensure a smooth transition of ownership, a buy-sell agreement should detail the process and timing for this to happen.
• Bankruptcy. A buy-sell agreement should anticipate that one business partner may have to file for personal bankruptcy, a development that could complicate ownership. This is because in a bankruptcy, the court appoints a trustee to oversee the bankruptcy and the trustee’s actions and decisions could be disruptive to the business’ operations. However, a buy-sell agreement that triggers a buy-out in the case of a partner’s bankruptcy would help minimize the potential for such a problem.
• Divorce. A buy-sell agreement should also address the possibility that one of the partners in a business may become involved in a divorce because divorce can impact a business, especially if the divorcing partner’s spouse in involved in the business. After all, no one wants to work with two disgruntled spouses! Note: To make this provision legally enforceable, all spouses must sign the buy-sell agreement.
• Involuntary Removal. It’s always possible that a partner may need to be removed from the business because of their misconduct. For example, they embezzled from the business or have harmed the business’ reputation in some way. All actions that would lead to removal need to be spelled out in a buy-sell agreement. 

The more comprehensively a buy-sell agreement identifies and describes all triggering events, the less room there will be for misinterpretation and conflict down the road.

2. A valuation methodology

Establishing a fair price for the ownership shares of a company is critical to a buy-sell agreement. Vague, inaccurate or outdated valuations can lead to disputes among owners, their heirs, and even with the IRS, which could result in costly litigation and potentially more taxes. For example, a recent U.S. Supreme Court case found that the partners in a particular business did not use a qualified appraiser to determine the value of their company, and as a result, the court found that they owed additional taxes.  

There are several methods for accurately valuing ownership shares. They include:

• Establish a fixed price for the business. Once a price has been agreed upon, it should be reviewed on a periodic basis and updated as necessary. Although the simplicity of this method makes it attractive, its drawback is that the agreed upon price can quickly become outdated.
• Use a formula. A formula-based approach that takes into account factors like revenue, earnings, or book value, offers a balance between simplicity and accuracy, but it’s critical that the right formula be used. Although business partners can create their own formulas, it’s always best that they seek professional help because an experienced business attorney, a financial advisor and a CPA can share time-tested formulas.  
• Combine methods. For example, combine a professional appraisal with a minimum or maximum fixed price. 
• Hire a qualified independent appraiser to determine the fair market value of the business. This is generally considered the most accurate method, but it can be expensive.

A buy-sell agreement should clearly spell out the chosen valuation method, the frequency of reevaluation, and the process for resolving disagreements regarding the valuation. And by the way, if the partners in a business include parents and children, the IRA will require a qualified appraiser because the agency will always assume that family members will use a low value as a means of giving the younger generation a “break” on the business’ price. 

3. A funding mechanism

A buy-sell agreement should clearly outline how a purchase will be funded once a triggering event occurs. Among other things for example, it should spell out any payment terms, interest rates, and collateral requirements.

Common funding mechanisms include:

• Use the proceeds from a life insurance policy. Insuring the lives of each partner can provide the necessary funds if one of the partners leaves the business due to their disability or death. Although this is a popular and cost-effective method, the U.S. Supreme Court just ruled on a buy-sell case that was funded using life insurance proceeds and the result was not good for the business owners because of the way the agreement was structured. (This is the same case that was referenced previously.) Partners interested in using this funding mechanism should always consult with an experienced life insurance professional and a business attorney.
• Make installment payments. This mechanism would allow the buyer to pay for the seller’s shares in installments over a specified period of time. Although this arrangement can ease the financial burden on the buyer, careful consideration needs to be given to interest rates and how the deal will be secured because if the buyer defaults on the deal, the seller may have no other option but to sue for the money they are entitled to. Installment payments are particular risky for a service business because if the buyer defaults, there will be little collateral for the seller to go after to satisfy the unpaid note, possibly leaving the seller with no other option but to go after the buyer’s personal assets.
• Use cash on hand: If the company or its remaining partners have sufficient cash reserves, they could purchase the seller’s shares outright.
• Get a loan from a bank or other financial institution. The business or the remaining shareholders could borrow the funds needed to buy out the departing shareholder.

4. Tag-Along and Drag-Along clauses

A buy-sell agreement should address the possibility that a company’s majority owner may want to sell their share of the business, but the buyer of the majority seller’s interest does not want to purchase the minority owner’s interest too. For example, one partner owns 60% of the company and has a buyer for that share, but the buyer is uninterested in purchasing the other 40%. A tag-along provision can force the buyer to purchase the minority owner’s share too.

Conversely, it’s possible that when the majority owner wants to sell their share of the business,  the buyer wants to purchase not just that owner’s share, but the entire business, and the other owner does not want to sell their share. Including a Drag-Along clause in a buy-sell agreement would address this situation by forcing the minority owner to sell thus preventing them from holding the deal “hostage” or even killing it. 

5. Dispute resolution

Disagreements between owners can arise even if there is a well-drafted buy-sell agreement. Therefore, every agreement should include a clear process for resolving disputes, such as using mediation or arbitration. Otherwise, settling them could involve costly and time-consuming litigation.

A well-crafted buy-sell agreement that includes the five critical provisions described in this article is an indispensable tool for protecting the interests of all business owners, creating a solid foundation for a business’ future, and for helping ensure a smooth transition of ownership. However, as the article has already made clear, crafting such an agreement requires the assistance of an experienced business attorney, financial advisor and CPA.  Business owners should never attempt to draft their own buy-sell agreement.