Going into business with someone is very similar to a marriage. There will be ups and downs, great memories and trying times. For the same reason many wealthy individuals see value in prenups, every business partnership should see value in a buy/sell agreement. It’s a plan for your worst days that you make during your best days and when partners are on the best terms.
What is a Buy/Sell Agreement?
A buy/sell agreement is a contract between business partners that outlines conditions under which a partner’s interest in the business will be bought out by the other partner or the business itself. You and your business partner may work great together, but if they passed away, would you and their spouse be as compatible? This is why a business should have a buy/sell agreement stating the triggering events, the value of the business (or calculation method), how it is funded and how the purchase will occur if a partner has a triggering event.
What Types of Events are Covered by a Buy/Sell?
The most common event covered by a buy/sell agreement is the death of a partner. As I used as an example before, your business partner will likely not want to be your spouse’s business partner if you die. The buy/sell agreement outlines the actions that are taken upon the death of a partner.
Many buy/sell agreements stop there, which is a major issue since there are many other conditions to address. The next most common triggering event covered is retirement or exiting the business. The agreement will state at what value and how the exiting partner shall relinquish their interest. It could be as simple as a right of first refusal to the other partners before selling to an outsider, or it could be a set formula and payment schedule the remaining partner must pay upon notice of retirement.
The most commonly overlooked event a buy/sell should also address is a disability. If a partner becomes permanently disabled or disabled for an extended period of time, does the other partner want to pay them their share if they aren’t working? A well-crafted buy/sell agreement will also address this and the actions that require the disabled partner to be bought out at a specified value.
How is it Funded?
Many businesses are worth far more than what they have in the bank, and even if they have enough money in the bank, it usually does not make sense to drain all their money on a buyout. So how is it funded? Each area of a buy/sell is funded differently.
Typically, if a buyout is triggered by death, it is funded through life insurance. Upon execution of a buy/sell agreement, each partner has a life insurance policy equal to the value of their ownership interest taken out. The most common mistake is that partners try to save money by acquiring term life insurance, and the insurance expires prior to a triggering event and creates a similar if not worse event than if they had no agreement. I strongly recommend using permanent whole life insurance to avoid this problem.
When it comes to retirement from the business, there are many creative ways partners find to fund this. One common method is a percentage of revenue from the business over a set number of years. Other partners set a percentage of profits each year into a separate account to eventually fund this event. Some look to acquire funding from a bank when a partner gives notice of their desired exit. There is no universally correct answer for this, and partners should consult their attorney, CPA and financial advisor on what works best for them.
Disability buyout is the most overlooked and, in my opinion, the most important event that should also be covered by insurance. There are specific disability policies designed for disability buyouts. But you need to be aware of the language. What you consider a triggering disability event and what the insurance company deems a triggering disability event may not be the same. It is imperative this language matches, or you may have an event that triggers the agreement to cause a buyout, but your insurance policy says no. You want to acquire a disability buyout policy that has a strong own-occupation coverage clause and have that language placed in the agreement so there is no confusion.
As with many things when it comes to business, a buy/sell agreement is not something a single advisor should consult on. It is recommended you have your business attorney draft the agreement, your CPA review the tax ramifications of how the agreement works and a financial advisor review proper funding. Failing to plan is setting up a surefire plan to fail. Create your buy/sell agreement early on in your business, and re-evaluate it every three to five years.
–Robert Depalo, Forbes (5/13/2019) – https://www.forbes.com/sites/forbesnycouncil/2019/05/13/why-business-partners-should-always-have-buysell-agreements/