What Is a Buy-Sell Agreement for Businesses?
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When starting a business, you’re likely not thinking about the day you’ll leave the company. But when that time does eventually arrive for you or your business partners, a buy-sell agreement would ensure a smooth transition.
The purpose of a buy-sell agreement is to provide an exit strategy for the owners of a business. Whether a shareholder leaves on a positive or negative note, the buy-sell agreement would outline how the remaining owners would handle the buyout.
We’ll help you understand how to draft an effective buy-sell agreement to prepare for ownership changes within your business.
- What is a buy-sell agreement?
- How to set up a buy-sell agreement
- Putting your buy-sell agreement into practice
- Final word
What is a buy-sell agreement?
A buy-sell agreement is a legal document that describes the transfer of ownership within a business. If an owner decides to leave the business, voluntarily or involuntarily, the buy-sell agreement would provide instructions for transferring their share of the company.
“It’s applicable when there’s multiple owners of an entity,” said business attorney Briana K. Wright. “Generally, it’s all sunshine and roses at the beginning. Once things are going downhill or you’re in a situation where you actually need it, then things can get messy.”
The document would define the events or actions that would put the buy-sell agreement into effect. Those “triggering events” could include any instance in which you or the other owners would want to control a change in ownership, Wright said. Those events could include retirement, succession planning, the death of an owner or any other unforeseen circumstance in which an owner could not continue their role within the business.
Because some triggering events could be unexpected, a buy-sell agreement should be in place as soon as the business is formed. You could think of it as a prenuptial agreement for businesses — it would be best to have an agreement in place before the relationship dissolves.
Provisions of a buy-sell agreement
The buy-sell agreement allows co-owners to control who ends up with ownership upon the exit of one of the shareholders. For instance, if an owner does not want to go into business with their co-owner’s spouse, then the buy-sell agreement would prohibit the spouse from receiving ownership rights, Wright said. Instead, the remaining owner or the company itself would need to purchase the departing employee’s shares in the company.
Specific provisions of a buy-sell agreement could include:
- Call rights: The company could buy out a partner at any time for a premium price.
- Put rights: Owners can request that the company buy them out at any time, possibly at a price below the value of the business.
- Deadlock provisions: This provides a way for one or all owners to exit the business if there is an impasse in decision making.
- First right of refusal: If existing owners or the company waive their first right to purchase shares, the departing owner can sell to a third party.
Adding these provisions to your buy-sell agreement would provide a contingency plan for unexpected obstacles when someone wants to leave.
Valuing the business
In addition to outlining steps to buy out a partner after a triggering event, the agreement should provide instructions for determining the value of the company and each partner’s share. The value should either be stated in the buy-sell agreement, or the document should instruct business owners to get an appraisal of the company when a triggering event occurs, Wright said.
“Generally, you get an appraiser at the time of the triggering event and get fair market value,” she said. “The appraiser is going to know what factors to consider.”
Fair market value is one of several types of valuation, and it reflects how much the business would be worth if it were put on the market. It’s often used to value a business in estate, inheritance or gift transactions, IRS-controlled ownership transfers or the sale of a business in an auction or on the open market.
You could also use fair value to determine what the business is worth. Fair value does not take market volatility into account. Each share of the business would be valued in proportion to the worth of the business as a whole. Fair value is typically used in the case of shareholder and partner disputes or for shareholder buy-sell agreements when shares are being internally transferred.
How to set up a buy-sell agreement
You and your business partners may want to consider hiring legal counsel to draft your buy-sell agreement. To minimize any confusion or complications when transferring ownership, a business lawyer could use language that reflects the interests of all parties. A poorly written agreement could do more harm than good.
“When you don’t have the knowledge about what could happen, you’re probably going to miss something,” Wright said. “If it’s not written correctly, sometimes things can get really messy.”
Each owner could consider hiring their own attorney to review the document, Wright said. This would ensure that the buy-sell agreement supports your goals as well as the objectives of your partners.
When searching for a business attorney, look into their professional experience to make sure they’ve handled buy-sell agreements in the past. Some lawyers specialize in certain areas of business and it may be helpful to hire someone who has experience in your industry.
The cost of legal services would depend on the nature of your request, and an attorney may not be able to give you a set price upfront. Most attorneys bill by the hour, but others could charge a flat fee for a single service, like reviewing your buy-sell agreement. If you expect to need your own lawyer going forward, you could pay a retainer fee and reach out as needed.
Putting your buy-sell agreement into practice
Once drafted, the buy-sell agreement would be embedded into the business’ operating agreement. An operating agreement is a document outlining the internal functions of a business, including rules and regulations. The operating agreement would also address the portion of shareholders’ ownership and distribution of profits and losses, which would relate to the buy-sell agreement.
When a partner leaves the business, you would have to adjust the ownership percentage among the remaining partners. If the business is a corporation, the remaining owners could draft a stock repurchase agreement to buy back the exiting partner’s shares in the company. The agreement would reflect the adjustment for all owners who repurchased stock.
For other types of businesses, transactions could be executed with cash or other forms of business financing. Partnerships or limited liability companies may also be required to file forms with their state’s government to document ownership changes.
The buy-sell agreement should outline the process for transferring ownership that you and your partners chose when first starting out. If you decide the value of the business ahead of time as well, or lay out a method for determining the value of individual shares, then you could reduce the chance of conflict, Wright said.
Like any relationship, the break-up of business owners could be an amicable or hostile situation. Having a legal document in place to guide you and your partners through the buyout process removes the opportunity for you or others to debate the value of shares and the percentage of ownership.
“If you draft a buy-sell agreement properly in the first place, once that [triggering] event happens, there’s really not that much to do,” Wright said.