Understand Buy-Sell Agreements: Safeguard Your Business Against Death, Disability, Divorce, and Disputes

A Buy-Sell Agreement Can Protect Your Company

Businesses with multiple owners face unique challenges in planning for the future. A buy-sell agreement, sometimes called a buyout agreement, is an arrangement between business partners to govern potential ownership transitions if one partner leaves the company, either voluntarily or involuntarily — i.e., the ‘four D’s’: death, disability, divorce, and disagreement.

A buy-sell agreement protects the company and the owners. It outlines how to handle a departing owner’s shares. This is typically done in one of two ways:

• Redemption agreement: This is also called an entity purchase or liquidation of interest. The company will purchase the departing owner’s shares. Suppose the plan includes life insurance or disability insurance. In that case, the company will be the beneficiary and use the insurance payout upon an owner’s death to fund the purchase of the shares.
• Cross-purchase agreement: Unlike an entity purchase, a company itself does not purchase an owner’s shares. Instead, each individual owner purchases the departed owner’s shares and benefits from any life insurance plans. This means that each owner must take out a life insurance plan on each of the other owners.

The type of agreement that is most beneficial to your company will also depend on your company’s legal structure, so it is best to speak with an expert regarding your company’s particular situation.

Your agreement will provide some protections and advantages, depending on its use. Below are how businesses use buy-sell agreements in each of the four D’s.

Advantages of a Buy-Sell Agreement: The Four D’s

Death

In the event of an owner’s death, the surviving spouse or family members may inherit the company’s shares. The buy-sell agreement outlines how the remaining owner(s) or company can buy those shares. The agreement protects the company and its owners by prohibiting the deceased owner’s family from selling the shares to someone else. Instead, the estate agrees to sell stock to the remaining partner(s) in exchange for cash. A good buy-sell agreement includes a life insurance policy. It provides cash to buy the shares of a surviving spouse. A cross-purchase agreement may be more complicated depending on the number of owners because it requires each owner to take out a life insurance policy on one another and calculate and coordinate the distribution of shares based on ownership stake.

Disability

Another advantage of a buy-sell agreement is that it provides for contingencies, such as an owner’s disability. There are many ways to structure this part of the agreement, but insurance often plays a big part. When an owner can’t work, the other owners may buy them out from the disability payout. Or the agreement may mandate the sale of shares of the company to ensure the injured or sick owner continues receiving income.

The traditional option to fund this type of buy-sell arrangement is disability insurance. But today, many life insurance policies offer a disability rider as an optional add-on. Bundled policies are usually cheaper than two separate ones. They may also cover more risks. Both options cover disabilities, long-term care, and serious health crises.

Divorce

In a divorce settlement, an owner’s former spouse may be awarded a portion of the company. One benefit of a buy-sell agreement is that it outlines terms to ensure the former spouse is compensated. The agreement avoids the risk of managing the business alongside a co-owner’s ex-spouse or losing control of the company altogether. Tensions are often high in a divorce. It is essential to protect the business from a new minority owner who may or may not have the company’s best interest in mind.

Disagreement

Like a divorce, businesses sometimes dissolve because of irreconcilable differences between owners. Buy-sell agreements can act similarly to a prenuptial agreement. They outline what will happen if the owners cannot continue their partnership. It is much simpler and less expensive to agree on the terms ahead of time than to battle it out later in court.

Protect Your Company

The vast majority of small and medium-sized businesses with more than one owner would benefit from the advantages of a buy-sell agreement, but only a small portion of them have one. The ‘four D’s’ can be planned for, but without a formal agreement, they can lead to financial ruin for company owners. Talk to your financial advisor or attorney to learn more about how a buy-sell agreement might be able to safeguard your company.

We think you’ll also like:

1. 6 Important Business Plan Mistakes to Avoid
2. How Choosing Your Company Legal Structure Affects Business Down the Line
3. Four Reasons Effective Marketing Strategies Require Patience

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Where Did All My Profits Go? Mastering the Concept of Working Capital
2. Understanding Risk Management Basics for Business Owners
3. How to Prepare for Sale

This is an updated version of an article originally published on September 18, 2018, and updated on March 3, 2021. This article was most recently updated by the Financial Poise Editors.] 

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.