Do you own a small business or plan to start a new business with a partner/co-owner? Have you considered what will happen in the event of your death or your business partner’s death? What if your business partner is sued for divorce or declares bankruptcy? All of these events (and more) may negatively impact the operation of your small business. It is important to plan ahead. Every business plan should include a well drafted “buy-sell agreement” that provides a roadmap during these events.
A buy-sell agreement is a legally binding contract between owners of a business. It creates the framework and sets forth terms for a voluntary or involuntary exit of a business owner. The essential terms of a buy-sell agreement provide:
(1) WHEN will an event trigger the buyout?
(2) WHO can buy the departing owner’s interest in the company?
(3) WHAT price will be paid for the owner’s interest?
Answering these three simple questions, IN ADVANCE, can often save thousands of dollars and help keep your business afloat. A buy-sell agreement can decrease the likelihood of fighting (and litigation) between family members, co-owners and spouses.
The WHEN Element:
The first element in every buy-sell agreement should determine when an event triggers the buyout. Upon a “triggering event,” the buy-sell springs to life and the provisions concerning who and what kick in. Triggering events typically include:
- Voluntary departure
- Incapacitation & Disability
A triggering event will cause a mandatory or optional buyout of the departing owner’s interest.
The WHO Element:
After the triggering events are determined, the next question is “who has the authority to purchase the ownership interest of the departing owner?” Typically, either the business or the other co-owner(s) hold this power. In a redemption agreement, the business itself would purchase the departing owner’s interest. In a cross-purchase agreement, the co-owner(s) hold the power to purchase the departing owner’s interest. You can also blend the two ideas and give the co-owner(s) the option to purchase, rather than making it mandatory, with the back-up purchaser as the business itself.
There are various factors to consider when choosing between a redemption or cross-purchase agreement, including: taxes, number of owners, insurability, etc. I will devote a separate BLOG POST to discuss and compare redemption vs. cross-purchase agreements. It is a complex subject in itself.
The WHAT Element:
This element (or lack thereof) tends to cause the most problems that lead to litigation. Why? Because it is all about the money. It sets forth the valuation method to determine the price to be paid for the departing owner’s interest in the business. It is vitally important that your buy-sell agreement clearly set forth the valuation method to prevent the possibility of litigation.
There are three primary methods to value a business and set a price in a buy-sell agreement: fixed-price, formula and appraisal. Each method carries different advantages and disadvantages. I will post a separate blog comparing the three methods.
The fix-price method is exactly how it sounds. The owners agree in advance to the exact price to be paid for the departing owner’s interest in the business. The formula method typically involves a complex calculation based upon various factors such as earnings, taxes, depreciation and amortization. The calculation may also be based upon the book value of the business. The appraisal method requires that a qualified business appraiser set the price. This typically occurs after the triggering event.
Discussing a buy-sell agreement with your business partner can often be a difficult task. Many people fail to realize the necessity of a buy-sell agreement. They believe their business relationship will always be happy and blissful. DO NOT bet your business (and livelihood) on good-intentioned optimism. Plan ahead. It will help protect your business and your relationships.