Protect Your Business From The Start
A buy sell agreement, also known as a buyout agreement, is a contract that provides for the sale of an owner’s share of a business. The sale may be triggered for several reasons, such as the owner’s retirement, bankruptcy, unresolvable conflict with another owner, death, or disability. The buyer may be another owner, employee, or third party.
The main reason to draft a buy sell agreement is that “hope” is not a good business strategy. If you don’t have a buy sell agreement, a number of bad things are quite certain to happen at some point in your business’ life:
- The business could wind up in the wrong hands, like the angry spouse of a former owner.
- Your business could die in the courts while surviving owners or heirs are contesting their rights and entitlements.
- Without specifying a ready buyer for your business in advance, you or your heirs may not receive fair compensation when you exit.
- If you or your heirs are forced to find a buyer for the business on short notice, expect the sale price to be far below fair market value.
A well-crafted, comprehensive buyout agreement eliminates the above risks.
a Buy Sell Agreement?
A buy sell agreement is a crucial part of planning for your small business’ future, says Mark Teitelbaum, Vice President, Advanced Markets at AXA Distributors.
If you have business partners, a buy sell agreement is especially important because it delineates the rights and responsibilities each owner has with regards to the continuity of the business. It gives you and your business partner(s) the opportunity to discuss and answer questions like, what would you do if you and your partner had an unresolvable conflict and one of you decided to leave the business? What if your co-owner suddenly passed away, and his or her spouse wanted in on the business?
Even if you are a sole proprietor, a buy sell agreement may be important. For example, you may have a long time employee that you want to take over the business upon your death, disability, or retirement. If you have a buyout agreement in place, the employee can pay a fair price to your heirs and take over the business after any of these events.
Mark Teitelbaum says these are some of the specific purposes that a buyout agreement serves:
- Keeps the business in the right hands – When an owner of a business passes away or becomes disabled, their share passes to their spouse, children, or other heirs. Similarly, if a business owner is involved in a divorce, the court can order him or her to share their business assets with the former spouse. A buy sell agreement protects you from having to run your business with a co-owner’s unprepared or emotional spouse or heir. It can give you the right to purchase your co-owner’s share, so that you can retain control of the business.
- It defines when you can sell your part of the business and to whom – A buy sell agreement specifies when business partners can “cash out” or sell a portion of their business interest or all of their share in a business.
- Specifies a fair price for the business – A buyout agreement specifies how the company should be valued. This ensures that business owners and their heirs get fairly compensated if the agreement is triggered.
To help convey the importance of buy sell agreements, we spoke to small business owners like you. Bryan Clayton, CEO of GreenPal, an Uber-type service for lawn care, said he felt a bit strange when first creating a buy sell agreement for his business but that it saved his business later on.
“When I founded my company with my two co-foundersfour years ago, crafting our buy sell agreement felt like creating divorce papers on your wedding date just in case you need them later. Luckily, we listened to our counsel and crafted the buy sell agreement ….because fast forward three years later one of my cofounders wanted out of the business because he was getting married and having a child. Life happens and you never know what the future holds.”
“Fortunately, in our case, we had a stack of documents to go back to and unequivocally discern what he was owed for his portion of the business. As you can imagine, it was a lot less than what he thought and that agreement quite possibly could have saved our company.”
— Bryan Clayton, CEO of GreenPal
Free Buy Sell Agreement Template
Business owners can create a simple buy sell agreement on their own using a free template.
However, it’s a good idea to get your agreement reviewed by an attorney to make sure you’ve hit on all the important points, included any required contractual language, and most importantly, customized the document for your own business’ needs. Click here if you need help finding a business lawyer.
What to Include in a Buy Sell Agreement
Every buy sell agreement is going to be a little bit different based on the specific situation of the business, but below are some of the primary things that a buyout agreement should include.
The first thing your buy sell agreement should address is what will cause the agreement to go into effect. We suggest sitting down with your business partner(s) soon after starting your business and discussing what would happen in each of these triggering events. It is best to discuss these things now with a clear head rather than later on when time is short or tensions are high. Triggering events may include the following:
When an owner passes away, his or her share in the business passes to their spouse, children, or other heirs. They may want to participate in the business, and that may not be okay with you. More often, what the heirs really want (and are legally entitled to) is their proportionate share of business earnings without having to work in the business or contribute anything to the generation of those earnings.
The buy sell agreement gives surviving owners the right to buy the deceased’s share from his or her heirs for the price stated or determined in the buyout agreement. Business owners often use life insurance to fund the buyout and pay the heirs (more to come on this later).
How would you feel about having to share earnings with a disabled partner who has been unable to work for several years?
If a business partner becomes disabled and can no longer work, the buy sell agreement can give other owners the right to buy out the disabled partner. Buy sell agreements should clearly define what a disability is and when the buyout would need to occur. For example, if an owner is ill for 3 months, is that a disability? What about 6 months or 1 year? In addition, the buy sell agreement should address what would happen if a disabled owner recovers and wants to rejoin the business. Business owners may use disability buy out insurance to fund a buyout if an owner becomes critically disabled (more to come on this later).
If a business owner gets divorced, a court may order that any assets, including his or her portion of the business, must be shared with the ex-spouse. In this case, the ex-spouse can exert control over the business. To avoid this, a buy sell agreement can give existing owners to right to buy out the business from a divorcing owner’s ex-spouse.
If a business owner becomes insolvent, it’s in the company’s interest for the other owners to buy out the bankrupt owner’s share. If not, the bankruptcy court may allow creditors to pursue the bankrupt owner’s share of the business to pay off debts. Typically, the agreement will state that a partner must inform co-owners if he or she is about to file for bankruptcy. At this point, the other owners have the right to buy out the insolvent owner.
In case an owner decides to retire, a buy sell agreement may provide that the remaining owners can purchase his or her share by paying fair compensation. The buy sell agreement should specify retirement age and define “retirement.” For example, what if a business owner wants to stop full time work but continue consulting for the business on a part time basis–would that count as “retirement”? In the agreement, a business may choose to provide lower compensation for early retirement and greater compensation if a business owner stays on past retirement age.
6. Conflict among co-owners
Unfortunately, one of the primary reasons that business owners exercise a buy out option is unresolvable conflict with a co-owner. If a disagreement cannot be resolved, sometimes the only option is for the owner to leave the business. When tensions are high, the exiting owner may demand a higher than fair share for their portion of the business, or they may try to sell their share to a third party that the remaining owner(s) doesn’t want to work with. The buy sell agreement ensures that the exiting owner gets fairly compensated for their share and may restrict them from selling their ownership share to a third party.
7. An owner threatens the business’ integrity
Sometimes, things escalate from conflict to something that’s more dangerous to the business’ future. For example, what if an owner becomes involved in criminal activity? Or what if an owner becomes mentally unstable? In these types of extreme situations, the other owners should have the right to force out the owner who has become a liability by buying out his or her share of the business. The buy sell agreement should delineate with as much specificity as possible the situations where a force out is permitted.
8. Voluntary “cash out”
Sometimes, an owner may want to leave the business voluntarily to pursue other opportunities or may want to sell a portion of his or her current ownership. A buy sell agreement can put limits on when an owner may cash out and to whom in order to preserve the integrity of the business.
The structure of a buy sell agreement will determine who buys the outgoing owner’s share and how much the buyer will pay.
The agreement can be structured in a way that requires the surviving owners be given the first option to purchase the departed owner’s share for the price stated or determined in the agreement. Alternatively, the agreement can legally compel the seller to sell and the buyer(s) to buy for the price or price formula stipulated in the agreement.
More specifically, Mark Teitelbaum at AXA Distributors says there are four common ways to structure a buy sell agreement:
1. Traditional Cross Purchase Plan
How it Works:
This is the most popular buy sell arrangement, particularly with businesses that have just two or three owners. With this type of plan, each owner agrees to purchase a co- owner’s share if that individual dies, becomes disabled, or leaves the business for another reason stated in the buy sell agreement.
Cross purchase plans are often funded by life insurance that each business owner carries on every other owner. Each owner pays the premiums (either from their personal funds or by taking money out of the business) and is the beneficiary of the policy. If an owner dies or becomes disabled, the surviving owner(s) can use the policy proceeds to purchase the interest from the deceased or disabled owner’s heirs.
Sarah and Josh are equal co-owners of Just Jewelry, a jewelry shop valued at $2 million. They sign a cross purchase buy sell agreement, and each buys a $1 million life insurance policy on the other. Sarah passes away. Josh files a claim with the insurance company and uses the $1 million proceeds to buy Sarah’s share of the shop from Sarah’s spouse. Now, Josh is the sole owner of the jewelry shop.
Small businesses with no more than 3 owners
- There will be an increase in cost basis for remaining owners of the business. In simple terms, cost basis represents the owner’s equity in a business for tax purposes. When a deceased owner’s interest is bought out, the remaining owners receive a “step up” in their cost basis, which will later result in lower capital gains taxes for them should they choose to sell their share in the business.
- This is a simple, relatively inexpensive option for 2 or 3 owner businesses.
- A cross purchase arrangement can be expensive and difficult to administer if there are more than 3 owners because each owner generally has to purchase an insurance policy on every other owner (e.g. 5 owners means 20 different policies need to be purchased!) – the exception to this is if a trustee or custodial account is used as a go-between for the buyers and sellers.
- A cross purchase plan can create inequities among owners because each insurance policy would have different premiums due to the different ages, gender, and other characteristics of the insured.
2. Entity Redemption Plan
How it Works:
In this type of plan, if a triggering event (e.g. death, disability, retirement, etc.) occurs, the business will buy the departing owner’s share of the business. This type of buy sell plan is often funded with a life insurance policy on the the owners that the business purchases and pays premiums on. The business can use the policy proceeds to purchase a deceased/disabled owner’s ownership interest from the heirs. The plan is called a stock redemption plan for corporations and an entity redemption plan for other types of businesses.
Sarah, Josh, Lucy, John, and Mark are equal co-owners of Sweetly Bakery. They sign a buy sell agreement that’s organized as an entity redemption plan. Sweetly Bakery purchases a life insurance policy on each owner. Josh passes away. Sweetly Bakery files an insurance claim and uses the policy proceeds to buy Josh’s share from his heirs. Sarah, Lucy, John, and Mark now rearrange their ownership shares so they are equal co-owners, each owning 25% of the business.
Businesses with more than 3 owners
- Less expensive option for businesses with several owners because the business just has to buy one insurance policy on each owner.
- Easy to administer and no premium disparities among co-owners because the business purchases one policy on each owner.
- No increase in cost basis after the first owner in a multi-owner firm dies, so it is not as favorable from a tax standpoint
3. One Way Buy Sell Plan
How it Works:
This option is often used when a sole proprietor wants a child, spouse, or a key employee to purchase the business if he or she dies or becomes disabled. The employee, spouse, or child would buy an insurance policy on the owner and be the beneficiary of the policy. The employee, spouse, or child might pay the premiums, or the business might pay the premiums on their behalf.
The other case where a one way buy sell agreement may come in handy is when there are multiple owners of a business, but it makes sense only for one party to buy out the other. For example, Mark Teitelbaum says, if there’s a business where two owners have a 60-40% ownership split, the 60% owner likely won’t need a buy sell option because he or she already calls the shots and can out-vote the other owners. The 40% owner would, however, benefit from a buy sell.
Jeff, age 64, owns a guitar shop and passes away unexpectedly. He has a 35 year old key employee Maria who has been with the shop for several years and manages many aspects of the business. Jeff and Maria signed a one-way buy sell agreement providing that Maria will purchase the business from Jeff’s heirs once Jeff dies. Maria takes out a life insurance policy on Jeff. While Maria could pay the premiums out of her paycheck, Jeff decides that the business should pay the premiums each month. When Jeff dies, Maria files an insurance claim and uses the proceeds to buy the business from Jeff’s heirs.
Sole proprietors that want an employee, spouse, or child to succeed them in the business.
- Simple arrangement that doesn’t require the purchase of multiple insurance policies.
- Good for family-run businesses or businesses that are dependent on a key employee.
- This option also works well if you want someone specific to succeed you upon retirement. If you get permanent life insurance, the individual can use the cash value built up in the policy to buy out your share when you retire.
- Must often be in conjunction with key man insurance. In the example above, Jeff should buy a key man insurance policy on Maria’s life because her death or disability could disrupt the business.
- Employee might not agree to pay premiums, in which case the business will need to cover the cost of premiums on the employee’s behalf. Depending on how the business chooses to characterize these premium payments–as a bonus or loan of the premiums or as a “lease” of the death benefits, the premiums may or may not be deductible to the business and will become taxable, to a greater or lesser degree, to the employee.
- Generally not effective for businesses with multiple co-owners.
4. Wait and See Buy Sell Plan
The last option for a buy sell agreement is the wait and see plan. This plan is a hybrid of an entity purchase and cross purchase plan. If an owner dies or becomes disabled, then the business gets the first option to purchase that owner’s share. If the business doesn’t buy it, the surviving owners have the right to buy the owner’s share to the extent they choose. If there’s anything left over after that, the business must buy the remaining share.
A wait and see buy sell arrangement is usually used at larger businesses. The main advantage of this type of plan is that it gives the business the ability to choose how to structure a buy out based on what is most attractive at the time the buy out occurs from a financial and tax standpoint.
A good buy sell agreement isn’t complete without identifying a fair price for the business. This section of the agreement determines how an exiting owner’s share of the business will be priced.
The most important thing to keep in mind when valuing a business in a buy sell agreement is that the business’ value isn’t static. The business’ value can change significantly over months or years. A good business valuation method needs to take that into account.
There are two main ways to set the business’ value in the buy sell agreement:
- DIY with a business valuation formula
- Professional appraisal from a business valuation professional
The less expensive option is to value the business with a formula. We suggest using a formula based on seller discretionary earnings (SDE) rather than net earnings or revenues of the business. SDE is the earnings of the business with irregular or non-recurring expenses added back in. SDE is multiplied by an industry multiple (e.g. SDE*5) to arrive at the value of the business. It’s a good idea to update the SDE and multiple annually so that there’s no disagreement after the fact as to whether the valuation is fair. In this article, we provide step by step instructions on figuring out your SDE and industry multiple.
The second option is to rely on a professional business appraisal at the time the buyout needs to occur. A professional appraisal can be expensive, running into the range of $2,000 to $5,000 or more. However, it takes the guesswork out of business valuation and puts it in expert hands. The professional will examine your business history and your books to come up with a fair valuation. The other advantage of a professional appraisal is that a third party is doing the work, so it’s more likely that all owners will find the process and the result to be fair.
Business brokerages often have certified valuation professionals on staff. Click here to learn more about brokerages.
Other Business Valuation Tips
No matter which business valuation method you choose, you should be very clear in your buy sell agreement about what will be included in the sale. Is it just physical assets of the business? Assets and debts? Is commercial real estate included? This is important to specify in the buy sell agreement so there aren’t any misunderstandings later.
Joshua Logan, principal attorney at Achieve Legal, explains why it’s important to specify exactly what’s for sale: “I’ve seen a dispute where a seller had personal property located at the place of business being sold and the buyer assumed that property was property of the business and part of the transaction–which led to the need to address the price before closing. Exactly what is and is not being purchased should be discussed in advance in the buy sell agreement.”
The best reason for including business valuation in your buy sell agreement? If there’s no agreed upon value for your share of the business, the IRS will do it for you if you pass away as part of valuing your estate. It’s much better to have some control over what the business is worth. If you have agreed to a value in your buy sell agreement, that will be used by the IRS for estate valuation as long as it’s a reasonable value.
The buy sell agreement should specify how the buyout will be funded if a trigger event occurs. In other words, how will the buyer afford to buy out the departing owner? A buyout can be funded in a number of different ways:
- Life insurance
- Disability insurance
- Installment sales
- Cash value in a permanent life insurance policy
- Stock options
- Deferred compensation arrangements provided to owners/key employees
For more details, see The American Institute of CPAs, which provides a comprehensive list of ways that a buy sell can be funded.
One of the most common ways to fund a buy sell agreement is with life insurance, which we discuss in greater detail in the next section.
Insurance products, explains Mark Teitelbaum, provide the security and assurance that the benefits will be paid as specified in the contract for a pre-determined cost. In addition, certain types of life insurance policies called permanent life insurance policies can be tapped into for their cash value when there is a lifetime triggering event like retirement. While loans may seem a reasonable alternative, banks may be unwilling to lend money or may charge a much higher interest rate since the business just lost its most valuable asset: you (or another owner)!
A combination of funding sources may be appropriate in some cases. It depends on the buyer’s resources, the business valuation, and how the buy sell agreement is structured. If a buyout is financed with cash, the buy sell agreement could approve a payment plan or installment plan. For example, the buyer could put down a deposit when the trigger event happens and pay the remainder over the course of 3-5 years.
Installment sales are not uncommon, but the heirs are taking the risk that the remaining owner(s) will be able to continue to run the business sufficiently profitable so as to afford the installment payments. If that proves to be wrong,Mark Teitelbaum cautions, the heirs lose their income stream and find themselves now holding a failed, worthless business.
Funding a Buyout Agreement with Life Insurance
Buy sell agreements go hand in hand with insurance. Why? Without an insurance policy, the prospective buyer may not be able to afford the buyout. The proceeds of an insurance policy provide a lump sum of cash for the buyer to purchase the exiting owner’s share of the business. It also protects the exiting owner’s interests by ensuring that cash will be available for his or her heirs.
Life insurance coverage that’s used to fund a buy sell agreement can be structured in different ways, depending on how the agreement is arranged.
In an entity purchase buy sell agreement, the business is the owner, beneficiary, and pays the premiums on the policy. In a cross purchase, the owners own policies on each other. They are the listed beneficiaries and usually pay the premiums (though the premiums can come out of the business’ income as well). In a one-way buy sell, the prospective buyer buys a life insurance policy on the owner.
There are two types of life insurance: term and whole/permanent life insurance. Term life insurance is most popular and the most affordable type–it covers the insured for a specific period of time and then needs to be renewed. Whole/permanent life insurance is more expensive, but it covers the insured for their entire life. It also has one other big advantage: It accrues a cash value that can be tapped into during the insured’s life. This can come in handy if a buy sell agreement is triggered by retirement, voluntary departure, or another lifetime event.
Priyanka Prakash is Managing Editor at Fit Small Business. In addition to overseeing a team of a dozen writers, she also writes on topics ranging from retail to law to insurance. Priyanka is also responsible for ensuring the efficiency and integrity of Fit Small Business’ publication process. Priyanka is a licensed attorney, and before joining Fit Small Business, she served as in-house counsel at a tech startup. When not writing or editing, you can find Priyanka rollerblading, reading a good mystery, or exploring Brooklyn with her husband and daughter.