Why You Need a Buy-Sell Agreement
The majority of businesses are small, closely held operations, typically owned by a group of friends or family members. Usually such businesses have somewhat informal structures that reflect an atmosphere of friendship, trust, and mutual respect that the owners have for one another. As long as the same core group of people shares common goals, such arrangements work very well. Unfortunately, the practical realities of life often intrude.
Consider what would happen to this sort of business if one of the principals files for divorce and her ownership interest is tied up in family court. What if one of the owners falls on difficult financial times and decides to sell her ownership interest to someone else--or worse, files bankruptcy and loses her ownership rights to third party creditors? How would the business be impacted if one of the principals died and her Last Will and Testament left everything to her young children? Any of these events could result in an inexperienced or adversarial individual becoming involved in the business.
How can a closely-held business plan for such contingencies and ensure that the business remains in the hands of the people who started it? The answer lies in a buy-sell agreement.
A buy-sell agreement is a contract that provides for the orderly disposition of a departing owner's interests upon a triggering event, such as death, incapacity, resignation, or proposed sale. Such an agreement potentially benefits both the business and the departing owner. For example, a buy-sell agreement can prevent ineligible persons or entities from owning a share in the business, while guaranteeing that the departing owner or her estate will have a market for her ownership interests.
Ordinarily a buy-sell agreement will specify that either the business itself or the remaining co-owners must purchase the ownership interests of the departing owner upon her death, disability, or resignation. Sometimes the agreement will specify a fixed price or a formula, or the owners may set the price themselves at their annual meeting. Buy-sell agreements may also provide the remaining co-owners a preferential purchase right, meaning that the departing owner must first offer her shares to the remaining owners upon the same terms as a proposed sale to a third party.
The buy-sell agreement will specify how the departing owner will be paid. Unfortunately the departure of an owner is often unexpected, resulting in a cash flow disruption. Consequently, the buyout provisions often contemplate installment payments over some period of time, or require the business to maintain life and disability insurance on each of the owners to provide a source of funding at the appropriate time.
A buy-sell agreement is an essential component of the small business succession toolkit. Indeed, it is difficult to imagine any closely-held business with more than one owner that would not potentially benefit from having such an agreement in place. By limiting free transferability of ownership interests and providing liquidity to the departing owner, a buy-sell agreement drafted by an experienced business law attorney will minimize or avoid many of the problems associated with succession of closely-held businesses.