What You Should Know About Buy-Sell Agreements
1. What is a Buy-Sell Agreement?
A Buy-Sell Agreement is a written document establishing a plan for purchase and sale of business interests, should certain identified events occur. The identified events – commonly referred to as “triggering events” – often include death, disability, retirement, divorce, or receipt of an offer by a third party to purchase an owner’s interest.
In some cases, the provisions of a Buy-Sell Agreement may be incorporated into corporate by-laws or a LLC operating agreement.
2. What are the objectives of a Buy-Sell Agreement?
The primary objective of a Buy-Sell Agreement is to eliminate uncertainty regarding the terms under which a departing owner’s interest will be transferred. Other general objectives are:
- Restrict undesirable parties from obtaining ownership or control of the business.
- Enable a smooth transition of control during times of major change.
- Provide a method for funding the buyout of a departing owner.
- Ensure a departing owner (or the owner’s surviving family) obtains a favorable buyout price.
- Establish the value of the business for federal estate tax purposes.
3. What are the types of Buy-Sell Agreements?
There are three types of Buy-Sell Agreements:
- Cross-purchase agreement. Under a cross-purchase agreement, the remaining shareholders will either have the option, or be required to, purchase a departing shareholder’s interest.
- Redemption agreement. Under a redemption agreement, the business will have the option, or be required to, purchase a departing shareholder’s interest.
- Hybrid agreement. Under a hybrid agreement, the business will have either an option or obligation to purchase a departing shareholder’s interest, but is also permitted to assign its right to the remaining shareholders.
Each type has its advantages and disadvantages and should be carefully considered. In general, a cross-purchase agreement works better when there are only two or three owners. If there are many shareholders, a redemption agreement is simpler to manage. Of course, there are many other factors – many of them very complex – that should be reviewed when establishing a Buy-Sell Agreement.
4. How is the sale price determined?
The process for determining the sale price is a critical issue in Buy-Sell Agreements. One method is for the owners to set a fixed sale price and review it annually. A second method is to use the book value of the business. Both of these methods are relatively straight-forward, but have major flaws. The better choice is usually to provide for an appraisal of fair market value by a qualified business appraiser. Although more expensive than the first two methods, an appraisal benefits from an accurate portrayal of the business at the time a triggering event in the Buy-Sell Agreement occurs.
A comprehensive Buy-Sell Agreement will also describe the terms for payment of the sale price. Unless life insurance is available to fund the payment in full, an amortized payment schedule over several years may be most workable for the business.
5. How can life insurance be incorporated into a Buy-Sell Agreement?
Few businesses have the funds on hand to buy out a deceased owner’s interest in full. The solution is often purchase of life insurance to provide the necessary liquidity when needed.
Term insurance is used commonly because it offers the lowest premiums. However, there are disadvantages of term insurance. Its very nature is that it provides coverage for a specified term and then expires. A permanent cash value type life insurance policy is preferable, but will be much more expensive. For young, cash-poor businesses, a convertible term insurance policy may be appropriate. This type of policy starts as a term policy and can be converted to a cash value type policy when the business can afford it.
6. How much does a Buy-Sell Agreement cost?
Buy-Sell Agreements can be very complex. There are many hidden issues to be considered. For these reasons, the fee to have a qualified attorney prepare a Buy-Sell Agreement is likely to be at least several thousand dollars.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
Thomas J. Bouman, Attorney
Bouman Law Firm
7650 E. Broadway Blvd. #108
Tucson, AZ 85710
(520) 546-3558
