Business owners are often too occupied growing their businesses to worry about unforeseen life events that can upend all their work. Death, divorce, and disability are three events that can have significant financial consequences for a closely held business. One of the best methods for mitigating those risks is through a buy-sell agreement.

What is a buy-sell agreement?

A buy-sell agreement is a contract, usually between the key business partners, which typically establishes how an owner will be bought out upon the occurrence of certain life events, such as death or disability. The agreement sets out a valuation method for a partner’s interest, as well as the timing of payments. Buy-sell agreements can also include other elements, such as management succession and voting control.

Buy-sell agreements can be structured so that the business redeems the exiting partner’s interest. Alternatively, the partners may agree to buy each other out upon exit.

Why is a buy-sell agreement important?

Below are the key reasons a closely held business should have a buy-sell agreement:

1. Creating business continuity: A good buy-sell agreement will set out clear procedures for ownership transition upon the exit of a key partner.
2. Managing competing interests: Creating consensus on how ownership interests will be valued and transferred safeguards the interests of all interested parties including successors and heirs.
3. Mitigating risk: Having agreed-upon terms for a partner’s exit helps minimize uncertainty during otherwise disruptive events.
4. Facilitating succession planning: A buy-sell agreement creates a framework for management succession and minimizes disruption of operations.
5. Preventing costly litigation: Negotiating the terms of exit and transition in advance reduces the likelihood of disputes among business partners that could lead to expensive legal battles.

Funding a buy-sell agreement

Buying out a partner with a large interest in the business generally requires access to cash far in excess of ordinary operating reserves. The most common ways of generating the necessary funds are:

1. Life insurance: This is one of the most popular methods. In the case of a redemption, the business most often buys policies on the life of each partner. In a cross-purchase agreement, partners most frequently own policies on each other.
   • Pro: Policy provides instant cash upon the death of a partner. If properly structured, the death benefit may be exempt from income taxes.
   • Con: The cost of insurance can be prohibitively expensive or possibly unavailable for partners with poor health.
2. Cash reserves: The business or the remaining partners can use cash reserves to buy out the exiting partner’s interest. This method requires maintaining a significant amount of liquid assets.
   • Pro: Avoids the annual cost of insurance premiums.
   • Con: Reduces the amount of operating cash available for business investment.
3. Bank loans: The business can take out a loan to fund the buyout when it’s needed. This method provides immediate funds and requires minimal planning. However, it adds debt to the business's balance sheet.
   • Pro: Avoids the annual cost of insurance premiums.
   • Con: Partners incur bank interest at potentially high rates. Interest expense deduction may be subject to limitations.
4. Installment payments: The purchase price can be paid over time in installments as agreed by the partners.
   • Pro: Avoids the annual cost of insurance premiums.
   • Con: Can put stress on future business cashflows.
5. Sinking fund: The company sets aside money over time in a dedicated fund in anticipation of a future buyout. Similar to using cash reserves, it requires the partners to accumulate cash rather than use it for operations.
   • Pro: Partners are investing in themselves rather than creating additional expense.
   • Con: Building a sinking fund requires time and a buyout may be needed unexpectedly and before the cash has been raised.

Because each method comes with pros and cons, many partners choose to fund buyouts with a mix of strategies.

Creating and maintaining a buy-sell agreement

Any business owner with the goal of business longevity needs a buy-sell agreement.

Negotiating a buy-sell agreement that works for both the business and its partners requires both financial analysis and robust negotiation. Because buy-sell agreements are intended to address a number of eventualities, it can take months to establish the terms and requires input from accountants, valuation professionals, insurance agents, attorneys, and financial advisors.

Once in place, a buy-sell agreement often requires maintenance and review to adjust for economic factors and changes in law. If your buy-sell agreement has not been reviewed in the last five years, please reach out to your advisors and schedule a meeting today.