What is a Buy-sell Agreement, Your Guide to Making the Right Choice

what is buy sell agreement

Business development takes years of careful cultivation and oversight by those that form and own businesses. At the end of the day, the financial strength of a company is only as strong as the quality of the management team that helped it to get there. When circumstances such as death, sickness, or retirement leave an owner’s position vacant, lack of proper legal oversight can lead to a number of disadvantageous outcomes for the company, its current owners, as well as the family of the previous owner. Buy-sell agreements help to put a legal framework in place that clearly outlines how ownership is transferred, and for what amount, when ownership is otherwise transferred from the individual leaving the position behind.

A buy-sell agreement is a legal contract that helps to distinguish and dictate how a person’s share of ownership should be distributed and otherwise transferred to others, with regard to situations where a position is left vacant due to unforeseen circumstances such as death or retirement. Through this agreement, the shares that were once owned by an individual who has left their position with the company, are sold back to the company or distributed to various remaining company shareholders in accordance with a previously agreed-upon structure or formula. The importance of a buy-sell agreement can be better understood in context to a more specific example that outlines the reasons that these agreements are so essential.

Why Are Buy-Sell Agreements Necessary?

In a hypothetical scenario, let’s say that one of the owners of a company passes away without putting a proper buy-sell agreement in place. This lack of preparation could lead to a variety of issues specific to the business entity, as well as the surviving heirs to the previous owner’s assets. Business valuation is one of the first points to consider, considering the value of the business may significantly decrease after the individual leaves the company. Next, when the portion of the business owned by the previous employee is passed along to their heir, it may be passed along to someone without any interest or expertise in fulfilling the duties of the position. In order for current employees to successfully navigate around this issue and regain complete control of their business, it is in their best interest to buy the previous owner’s remaining shares of the business. Unfortunately, the cost associated with reclaiming the previous owner’s shares can become quite expensive which could put the remaining business at financial risk. Further, if the remaining shares aren’t purchased, it could leave the former owner’s heir with little to no financial compensation.

Now, let’s consider a hypothetical situation where a buy-sell agreement is put in place before the business owner passes away. In this situation, there is a contractual obligation for the business to repurchase the previous owner’s shares from their heir. This ensures that the shareholders of the company have a relevant interest in seeing the company succeed, while also ensuring proper compensation to the former employee’s family. The purchase from the heirs occurs at a predetermined rate that is spelled out in the contract, prior to the owner’s death. In order to cover the cost of the reacquisition of shares, life insurance policies are purchased on fellow shareholders, which ensures that the entire amount of shares can be purchased and the heirs receive the full amount of money that is due to them.  

Types of Buy-Sell Agreements

Buy-sell agreements can be sorted into two main categories that are utilized today, differing in situational use based on the size of your business and how the shares of your business are distributed and owned. These two types of agreements are called Cross-Purchase Agreements or Redemption Agreements.

Cross-Purchase Agreements

These types of buy-sell agreements are best suited for companies with relatively few owners or shareholders. Cross-purchase agreements require enduring shareholders to purchase the interest of the deceased or otherwise absent owner. When cross-purchase agreements are made, specific details are added surrounding how the shares should be distributed and purchased by surviving members. An example of distribution guidelines might include passing the shares along in proportion to the surviving shareholder’s current stakes in the company. Ultimately, the ways the shares are distributed can be determined in a number of ways that will be discussed later in this article.

As previously stated, in order to ensure that owners are able to purchase and reclaim the shares without incurring serious financial burdens, partners will typically purchase life insurance policies on one another. This also ensures the deceased or absent owner’s family can fully realize the financial value of their loved one’s shares of the company. This part is particularly important for owners who have families who previously relied on an owner’s salary for sustenance, that they are no longer receiving. 

Insurance policies are accompanied by a number of pros and cons that make them wonderful resources in extenuating circumstances surrounding the loss of an employee, however potentially burdensome in the time leading up to their use. One of the biggest positive aspects of the insurance policies is that there is no need to pay taxes on the money that is collected on insurance, which can be a beneficial form of financial relief in particularly challenging times for employees.

On the flip side, one of the biggest deterrents to these policies lies in the fact that younger owners may need to pay higher premiums on the policies of older and less healthy partners, resulting in dramatically unfair payments for some individuals. Another deterrent to cross-purchase agreements is the large number of policy purchases that may need to be made for businesses with more than just a few partners. To put this in perspective, circumstances with only 5 partners results in the purchase of 16 insurance policies in total. At this level, the paperwork and logistics can become particularly burdensome.

Redemption Agreements

Stemming from the previous statements on the potentially high number of insurance policies that need to be purchased for companies with more owners, redemption agreements are a better fit for businesses with a higher number of partners. Life insurance policies are purchased on each of the partners, however, only one is taken out on each individual, which is done on behalf of the business entity itself. The policies are taken out in proportion to each partner’s respective stake in the company. This alleviates the need to buy a potentially cumbersome amount of policies, and in the event of the death of one of the owners, the business entity can collect the insurance pay-out to repurchase the deceased individual’s stake from their heirs.

The most important part of these policies is the granted capability for the business to purchase the deceased individual’s company shares without liquidating company assets, ultimately impacting the bottom line. As opposed to cross-purchase agreements, redemption agreements allow the cost of insurance policies to be evenly split between shareholders in accordance with their respective proportion of stake holdings. This alleviates the issues presented by younger and more healthy stakeholders having to pay higher premiums than older and less healthy partners. Unlike cross-purchase agreements, however, redemption agreements allow insurance claims to be seized by creditors to cover any debts that the business may have, which has the potential to lead to financial turmoil for the company, and the deceased shareholder’s heirs.

Methods of Business Valuation

An essential component to your buy-sell agreement, no matter the type that you move forward with, is including a framework for how the business’ value should be assessed. This can help to determine how much a shareholder’s portion of the company is worth when they leave their position due to circumstances such as retirement or death, so they can be repurchased at the correct price: no more, no less.  

Specifications for business evaluations are also extremely important in the determination of how much should be paid out to the family of the deceased employee in order to reacquire and distribute their holdings to retain company value and provide financial relief to the previous shareholder’s heirs. While each agreement will differ in their valuation methods, there are three main mechanisms for determining the value of the business, furthermore the value of a particular individual’s company stake. These three mechanisms include fixed price agreements, formula agreements, and business valuation agreements.

Fixed Price Agreement

As the name would suggest, fixed price agreements determine a specific set dollar value that the company is worth at the time the buy-sell agreement is formed, that the company will also be worth in the future when the agreement comes into play. Advantageously, this clears any ambiguity surrounding the value of the company, leaving little room for dispute or disagreement on how much the business should be valued at (which could be a potential issue in formula-based valuation methods). 

On the other hand, depending on the length of time the agreement is in place, and any major changes or shifts your business may have seen, this fixed value could be extremely outdated by the time the contract is put to use. Another point of weakness arises when considering that the fixed valuation could be inaccurate from the time the buy-sell agreement is put in place, by the time the contract is enacted, the valuation could be even further off from when it began.

Formula Agreement

Different from fixed price agreements, formula agreements determine the valuation of the business at the point when a shareholder leaves a role vacant. A formulaic approach is taken which accounts for a number of business metrics and values that communicate the best picture of what the business is worth at any given point in time. One of the main advantages to this type of agreement is that the valuation is not stuck in time, it’s able to fluctuate and grow (or shrink) as the business does. Despite the flexible nature, the criteria for valuation is still stated and known to all parties.

In this way, when the contract becomes active at the point of a shareholder’s vacancy, the individual’s shares will be purchased for no more or less than they are worth, ensuring that all parties can maintain their financial integrity. One of the biggest deterrents for this method of valuation is that no one has a looking glass into the future. Therefore, there is no way to ensure that the chosen metric or measure of business success/size will be an accurate reflection of the value of the business (and in turn the vacant shareholder’s stake) in the future. Still, a non-static measure may be a better alternative than fixed-price agreements for those predicting wide fluctuations in the value of their company long-term.

Business Valuation Agreement

Different from the previous valuation agreements, the business valuation agreement states that the determination of business value shall be made at the point the contract becomes active rather than the point in time the buy-sell agreement is established. As such, these types of agreements understand that determining the value of the company in the future is difficult (if not impossible) to predict in the present.

In many cases, once an owner leaves their position absent, a third-party expert is brought in to conduct a comprehensive valuation of the business at the point in time the value of the previous owner’s stake must be valued. Third-party valuation experts can take the guessing work out of how much the company is worth, and can also take out biased estimates that could lead to inaccurate assessments of the previous owner’s portion of shares. Including this type of agreement in your buy-sell contract could be advantageous for the purpose that lawyers are likely to be familiar with the structure, and it allows for the most accurate valuation at the point the contract becomes active. However, this may not be the best agreement for individuals who want a concrete understanding of exactly what might take place in the future. The value at which the former partner’s shares will be repurchased could be relatively uncertain until the time comes to set the contract into motion.

Methods of Insurance Valuation

Ultimately the decision of which agreement is best for your business should be made on a case by case basis of your needs, size, and ownership partners. Each agreement has its strong and weak points, and ultimately should be chosen based on what your partners are comfortable establishing in the present for your company needs in the future. No matter the type of agreement you move forward with, it will require the purchase of life insurance policies. Therefore, it is helpful to understand how large the policy purchase should be for each stakeholder. Insurance policy valuations can be sorted into one of three specific forms including book value, market value, and capitalization of earnings.

The first method of insurance policy valuation, the book value, takes into account company financial statements. This is calculated by subtracting the company’s liabilities from its assets. That being said, this valuation method is a great choice for companies that have a lot of physical assets as opposed to service-based industry companies. 

The next policy valuation method based on market value takes into account how much an entity would pay to acquire the company. Since market value more frequently results in a higher valuation than the book value method, it’s no wonder it’s more frequently used since it greatly reduces the risk of individuals being underinsured.

Lastly, the capitalization of earnings method takes into consideration the annual earnings in addition to forecasted future earnings. As opposed to the book value method, capitalization on earnings is a better option for service-based businesses without a lot of physical capital.

When To Put a Plan In Place

While you may not be expecting any of your partners to retire or otherwise reach the end of their career, buy-sell agreements work best when they are put in place long before they are needed. When decisions are made in high-pressure situations, you run the increased risk of ulterior motives coming into play when particular stakeholders grow vulnerable without a plan put in place prior. Especially in context to the unexpected death of a partner, there is an increased chance that emotions can work themselves into the process of decision making, which can be particularly straining for relationships, more specifically when there are ulterior motives at play.

Buy-sell agreements are not always the most exciting or comfortable conversations to have considering the involvement of potentially sensitive subjects. The added complexity of the process makes the processes seem even more overwhelming. Therefore, there is certainly the added benefit of working with experienced professionals who can make the process more accessible, seamless, and comfortable for all parties involved. When the time comes for one of your partners to have their company stake repurchased, your small investment of time and money will be well worth it in order to avoid a slew of financial headaches and strained relationships. Putting a plan in place today is the first step in guaranteeing the success of your successful business for many years to come.