A buy sell agreement has the potential to solve a major potential problem between owners in a small business. When entrepreneurs go into business together one of the last things they want to think about is the end of the arrangement. At the inception of any good working partnership is the certainty that everything will be great, the company will make lots of money, all of the owners will work hard, and no one will ever retire, die, or become disabled and no owner will ever want to sell to an outsider.

But, what if one of those things happens? How will the owner who leaves get paid out, how fast, what price, what if the remaining owners don’t have the money to cash out the owner who leaves? If the owners wait to address these possibilities until they rear their head, the problems get wider and deeper, lawsuits, court depositions, I have seen first hand how it can get ugly. If a Buy-Sell agreement is drafted at the beginning, when everyone is in the mood to be reasonable, owners can agree on price and terms for these eventualities and put the proper funding vehicles in place to mitigate financial issues. Both you and your fellow owner – whether a partner or another owner (or many owners) will have a much more rational conversation about the value of the business, terms of sale, and how to solve the problems of funding a sudden need to sell – or buy the other’s interest than during a stressful and unexpected event.

Let’s face it, no one knows the future – it is possible that you or your fellow owners may get sick, injured, or even pass away when no one is prepared. The Buy-Sell agreement provides a mechanism for an orderly business succession. It also affords the co-owners or the business entity the ability to maintain the option or mandatory obligation to purchase the interest from an existing owner in order to restrict outsiders or undesirable business partners from becoming owners. This is often a useful provision for family businesses.

Imagine being in business with your partner’s wife, or son, or brother – and not having a choice about it.
Some of the considerations should be:

• Valuation – how will the business be valued. Will it be a formula that you can decide on beforehand or an appraisal at the time it is needed? Many agreements call for different prices if a partner is forced to sell their interest versus leaving and unilaterally asking for their interest to be liquidated. Usually a premium over the valued price in the case of a force-out and a discount in the situation where the exiting partner wants to exercise a put to the company or other partners.
• There are as many different ways to value a business as there are owners. Some agreements have a pre-determined value or formula and some call for an appraisal at the time of the event. In some, the amount is tied to the insurance proceeds realized on the death of the owner.
• Timing – will you purchase your partner’s interest outright immediately or will it be bought over time? Will it be an earn-out based on future income or will the price be fixed at the date of purchase? Timing may depend in many cases on the funding in place to pay for the purchase.
• Funding – It is always difficult for a small business to come up with large amounts of funding on short notice. Many buy/sell agreements are funded through the purchase of life and disability buy out insurance – possibly the most efficient way to fund these unplanned buyouts. In the case of retirement, there should be an exit plan in place which considers the cash flow needs of the exiting owner and the company both.
• Tax Considerations - Different types of buyouts will have different ramifications for the remaining partners. Insurance can be owned by the business, or by the individual owners or a trust in a cross purchase scheme.

In an entity redemption, life insurance would be owned by the company. Generally, if the insurance is owned by the business and the business redeems the stock from the shareholders’ heirs there will not be a step up in basis for the other owners; in addition, there may be corporate AMT due on the death benefit depending on the corporation tax situation. In a cross-purchase, the life insurance is owned by the owners individually, there will be a step up in basis when they each purchase the stock - but with many owners, a cross-purchase can be messy and entail many policies (one policy purchased by each owner on all of the others).

Needless to say, an important agreement like a buy-sell should be reviewed on a regular basis. It is good practice to review the agreement at least annually to make sure the valuation formula or approach is still valid, any increases in insurance ar processed, and everyone still agrees on the terms. It also goes without saying that the agreement should be drafted by an attorney familiar with business matters.

In summary, it is important for owners to have a buy-sell agreement which is in place at the beginning of a business venture. It should be funded appropriately, written by an attorney, comprehensive, and reviewed annually.