Buy-Sell Agreement

A buy-sell agreement (also called a buyout agreement, business will, or business prenup) is a legally binding contract that specifies how an owner’s share of a business will be transferred if that owner dies, becomes disabled, retires, files for bankruptcy, or otherwise leaves the business. It defines who may buy the departing owner’s interest, how the interest will be valued, and how the purchase will be funded—ensuring continuity and preventing unwanted third-party ownership.

How it works

• Triggers: Typical events that trigger a buyout include death, disability, retirement, bankruptcy, divorce, or voluntary sale.
• Purchase obligation: The agreement requires that the departing owner’s share be sold either to the remaining owners or to the business itself according to a prearranged formula.
• Funding: Life insurance is commonly used to fund buyouts on a partner’s death. Other funding options include company reserves, installment payments, loans, or a mix of methods.
• Purpose: It prevents ownership passing to outsiders (for example, a deceased owner’s heirs), reduces the risk of control disputes, and provides a clear valuation method to resolve conflicts.

Types of buy-sell agreements

• Cross-purchase agreement: Remaining owners individually buy the departing owner’s interest. Often used when there are a small number of owners.
• Entity-purchase (redemption) agreement: The business entity buys back the departing owner’s interest and retires the shares.
• Wait-and-see agreement: The agreement doesn’t immediately designate buyer(s); at the time of the trigger, parties decide whether the business or the remaining owners will make the purchase based on what works best.
• Hybrid arrangements: Parts of the interest may be handled by different mechanisms (some shares bought by individuals, others by the company).

What to include

• Names of owners and current equity stakes.
• Valuation method and timing (fixed price, formula, appraisal process).
• Events that trigger a buyout.
• Who must or may buy the interest (remaining owners, company, key employees).
• Funding mechanisms (life insurance, cash reserves, installment terms).
• Tax and estate planning considerations and treatment of proceeds.
• Procedures for valuation disputes and deadlines for closing a buyout.

Advantages

• Ensures business continuity and stability after an owner’s departure.
• Prevents involuntary ownership transfers to heirs or outside buyers.
• Provides a predefined valuation method to reduce disputes.
• Facilitates estate planning by giving owners and heirs a clear exit mechanism.

Disadvantages and risks

• Restricts owners’ ability to sell interests freely to third parties.
• A fixed valuation or formula can become outdated and may over- or undervalue an interest over time.
• Legal, tax, and insurance arrangement costs—especially if drafted or revised by professionals—can be substantial.
• Poorly designed funding (inadequate life insurance, unrealistic installment terms) can leave remaining owners unable to complete a buyout.

How to establish an effective agreement

1. Engage professionals: work with an attorney experienced in business succession, a certified public accountant for tax implications, and a life insurance specialist for funding strategies.
2. Choose valuation method: agree on appraisal procedures, formulas, or periodic valuations and set review intervals (e.g., every 1–3 years).
3. Decide funding: select appropriate funding (cross-purchase insurance, corporate redemption policies, cash reserves, or financing).
4. Draft clear triggers and procedures: specify deadlines, payment terms, restrictions on transfers, and dispute-resolution mechanisms.
5. Review periodically: update the agreement after major changes in ownership, business value, tax law, or personal circumstances.

Practical tips

• Small or new businesses can use templates as a starting point, but consult legal and tax advisors for formal execution and complex ownership structures.
• Consider the tax consequences of cross-purchases versus entity redemptions; the choice affects both the buyer(s) and seller’s tax positions.
• Maintain adequate life insurance coverage and ensure beneficiary and ownership arrangements match the buy-sell mechanics.
• Communicate the terms to owners and relevant family members as part of broader estate and succession planning.

Bottom line

A well-drafted buy-sell agreement protects a business and its owners by defining how ownership transfers will be handled if an owner leaves. It preserves continuity, limits disputes, and provides funding and valuation mechanisms to facilitate orderly transfers. Drafting and maintaining the agreement with professional advice is essential to ensure it remains practical and fair as the business and ownership circumstances evolve.