Understanding the Basics of a Buy/Sell Agreement
For co-owners of a business, a buy/sell agreement—sometimes called a buyout agreement—is a necessity. The agreement protects owners in the event of a co-owner’s death, retirement or incapacitation, among other life events, and is designed to provide for as little disruption to the business as possible.
Buy-sell agreements are binding contracts that govern:
When co-owners can sell their interest in the business
What the purchase price of the interest will be
Who can buy it out
A properly drafted agreement also provides for a funding mechanism and establishes the appraisal of a former owner’s interest for estate tax reasons. The terms of a buy-sell agreement direct when a mandatory or optional buyout is triggered. For instance, all solid buy-sell agreements provide for the death or disability of a co-owner.
While a death of a co-owner would clearly spur such a buyout, the terms would also include what disabilities would cause the buyout to occur and would provide a timeframe for when the owner or the owner’s estate should receive payment. The terms would also determine whether the surviving co-owners or the business itself purchases the interest. In addition, such buyout terms would specify if the buyout will be funded from insurance, including life or disability.
Other life events that buy-sell agreements can prepare for:
Retirement of a co-owner
When a co-owner wants to leave the business or sell their shares
There are three types of buy-sell agreements, which each have their own advantages and disadvantages:
Cross-Purchase Agreements. In such an agreement, owners agree to purchase their departing co-owner’s interest at an agreed-upon price. Generally in this scenario, an owner will take out life insurance policies on their co-owners and list themselves as the beneficiary to fund a buyout triggered from the death of a partner.
Entity Redemption Agreements. Under this agreement, the business itself is obligated to purchase a departing owner’s interest, and the business entity would purchase life insurance policies on each co-owner. This would allow for the owners to not make out of pocket payments.
Mixed, or Hybrid, Agreements. A combination of the other two types, this agreement is designed to give flexibility when a buyout is triggered and allows either the business or business owners to purchase the departing owner’s interest. The arrangement allows for the owners to determine whether it would be more advantageous for the business itself or the co-owners to buyout the departing owner.
Buy-sell agreements also determine the valuation method that will be used to approximate the business’s market value. Business owners can choose several valuation formulas which include using book value estimates or determining value based on capitalization of earnings, among other formulas. The most important point is that co-owners agree on a method beforehand so everyone is clear on how the business will be appraised.
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