When two or more business partners own a company, a buy-sell agreement is a legally binding contract used to protect their entity in the event of their death or leaving the business.
The business may be sold to remaining partners, or it can be transferred in an asset sale to a new buyer. In that case, the buy-sell agreement can determine how the profits will be distributed among the remaining partners.
These are six important things to consider in your buy-sell agreement.
1. Buyout Conditions
Buyout conditions lay out the triggers for the buy and sell agreement to take place. For example, the below can all trigger the initiation of a buyout:
- A partner’s death
- Retirement
- Divorce
- Failure to fulfill responsibilities
The buy-sell agreement stipulates the available share the business partnership presents and how the existing partner’s share will be reassigned.
There are several types of buyout clauses that businesses may choose to incorporate into their agreement. These include:
- Wait-and-see clause : Owners agree to sell the share while waiting for specifics about the triggering event. This can provide greater financial flexibility, but it requires a great deal of trust and stability.
- Shotgun clause : This buyout agreement clause sets a fixed price for share purchases should one or more partners wish to leave the business or sell all of the shares.
- Drag-along clause : In a drag-along clause, the minority owners must agree to follow the decisions of the majority owner. Suppose there are prominent shareholders in a business. In that case, this clause allows them to sell without being stopped by minority shareholders who wish to retain their shares.
- Tag-along clause : Tag-along clauses allow minority shareholders to join any deals that the prominent shareholders wish to close. The final buy-sell agreement cost can benefit them financially as well.
Here is an article where you can learn more about buy and sell agreements.
2. Buy Sell Structure
The buy-sell structure should determine how a partner may go about selling their shares in a business. The main reason for a buy-share agreement is to prevent one partner from selling their shares or assets without the other’s consent.
The structure can be outlined in an asset sale, or partnership agreement detailing the business succession should the other partner wish to remain an entity owner.
Here is an article that describes the types of buy and sell agreements you may use.
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3. Company Valuation
A company valuation included in the buy-sell agreement should outline the market value of the business, its assets, and its partners' shares. If a partner leaves the business, the value of their share should be clear to prevent any confusion, court battles, or disputes over financial compensation.
Here is an article for more information on calculating a company’s value.
4. Funding Resources
As part of their exit strategy, the buy-sell agreement can outline what funding resources partners may use to cover the cost of the business purchase. In addition, the buy-sell agreement can be outlined in a way that prevents the company's operations and profits from suffering over the course of the sale.
Funding may include:
- Installments
- A bank loan
- Life insurance
Here is an article that provides more detail on funding a buy-sell agreement.
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5. Taxation Considerations
Buy-sell agreement taxes must also be taken into consideration. The sale of the partner’s share may be treated as a taxable dividend or stock share, depending on the agreement type.
The capital gains tax laws may influence how the sale affects both the partners and the business entity. The type of sale will ultimately influence taxation, and any liabilities partners face. For example, in a cross-purchase agreement, partners may receive a deceased partner’s life insurance benefits as a tax-free income.
In an entity purchase, acquired assets can become corporate property, which is subject to tax laws and creditors.
Here is an article that provides an overview of things to consider before selling a business in a buy-sell agreement.
6. Real Estate
The buy-sell agreement should also explain what will happen to any real estate the partner owned or shared before their death or exit. Ultimately, the goal of a buy-sell agreement is to prevent unnecessary loss and disruptions to the business in the event of one owner's death or departure.
Remember, you may include real estate shares and transfers as part of your agreement. It can consist of terms and conditions for the sale of a property as well as clauses that allow the departing partner to relinquish any rights to the property.
Here is an article to learn more about how to set up a buy and sell agreement.
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