Successfully owning and operating a business comes down to preparation and follow-through. One area you may not be considering when you’re building your company is what happens if you or another part owner dies or becomes incapacitated. These and other scenarios are covered by what’s known as a buy-sell agreement, which is an essential tool for protecting your business in the long run.
What is a buy-sell agreement?
A buy-sell agreement is a contract that stipulates what happens to a business owner or partner’s shares after they depart from the company. According to Investopedia contributor Will Kenton, these agreements are commonly used by partnerships and closed corporations.
Kenton writes that buy-sell agreements tend to take two forms: a cross-purchase agreement and an entity-purchase agreement. In the case of the former, the other members of the partnership or ownership group purchase the shares left by the departing member. In the latter, otherwise known as a redemption agreement, the business entity itself purchases the ownership shares.
A buy-sell agreement can also fall somewhere between cross-purchase and entity-purchase agreements, splitting the shares between the partners or co-owners and the business entity. Kenton notes another medium between these options called a wait-and-see agreement. In this case, the contract does not explicitly name partners or the entity, and the decision is made later with business stability in mind.
Buy-sell agreements are also common in sole proprietorships. In these cases, the buyer or successor is a key employee such as an executive. While a key employee may not have a direct ownership stake, the IRS considers them key to the business if they have control over more than 10% of the business’s finances and are among the top 20% in compensation or make more than $150,000 in reportable compensation in a tax year.
Common cases where a buy-sell agreement is needed
A buy-sell agreement helps create a clear path forward for the business in several instances. One, Kenton writes, is the death of a partner or co-owner. This agreement requires that the decedent’s estate sells shares back to partners or the business entity, preventing a potential power struggle. To achieve this, partners take out life insurance policies on one another. When the policy benefit is paid out, that money is used to purchase the shares.
Buy-sell agreements create clear guidelines for any instance in which a partner decides to exit a business. Meredith Wood, a contributor for NerdWallet and former vice president at Fundera, notes that this can include amicable instances like retirement or a partner simply wanting to cash out and move on. But it’s especially beneficial in cases where a partnership turns contentious. Even if you’ve started a business with your spouse and are confident in your relationship, a buy-sell agreement creates a contingency plan that will protect both parties’ interests in the event of a divorce or separation.
Whatever your reasons for establishing a buy-sell agreement and whatever your business structure may be, the best way to ensure its effectiveness is to work with an experienced attorney. An expert familiar with the language of buy-sell agreements can help you craft a contract that works for everyone involved and addresses potential oversights.
You may not be thinking ahead about what will happen with your business after you sell your shares, retire, or die. But establishing a buy-sell agreement today makes things less complicated in the future so you can focus on making moves in the present.