What is a Buy-Sell Agreement? Protecting Your Business in Event of Death, Disability, Divorce or Disagreement

When a Business Partner Departs, a Buy-Sell Agreement Can Protect Your Company

Businesses with more than one owner face unique challenges in planning for the future. A buy-sell agreement, sometimes referred to as a buyout agreement, is an arrangement between business partners to govern potential ownership transitions in case one partner leaves the company, either voluntarily or involuntarily—i.e., the “four Ds”: death, disability, divorce and disagreement.

One of the advantages of a buy-sell agreement is that it can protect the company and the remaining owners by outlining how the departing owner’s shares are handled. This is typically done in one of two ways:

• Redemption agreement—Also called an entity purchase or liquidation of interest, the company will purchase the departing owner’s shares. If the plan includes life insurance or disability insurance, the company will be beneficiary and use the insurance pay-out 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 is beneficiary of 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 also give you certain protections and advantages, depending on the circumstances under which it’s used. Below are the ways in which businesses use buy-sell agreements in each of the four Ds.

Advantages of a Buy-Sell Agreement: The 4 Ds

Death

In the event of an owner’s death, the surviving spouse or family members may inherit the shares of the company. 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. The estate instead agrees to sell stock to the remaining partner(s) in exchange for cash. As mentioned above, a well-structured buy-sell agreement includes a life insurance policy so there is cash available to purchase the shares of a surviving spouse. Depending on the number of owners, a cross-purchase agreement may be more complicated. That’s because it requires each owner to take out a life insurance policy on each owner, calculate and coordinate 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 often insurance plays a big part. When an owner isn’t able to work, the other owners may buy him or her out from the disability payout. Or the agreement may mandate the sale of shares of the company to ensure the injured or sick owner would continue 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 typically less expensive than two separate policies and may cover more contingencies. Both options cover disabilities, a medical issue requiring long-term care and other serious health crises. When one owner is not able to work because of these health issues, the insurance provides a pay-out.

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 having to manage the business alongside a co-owner’s ex-spouse or lose control of the company altogether. Tensions are often high in a divorce. It is important to protect the business from a new minority owner who may or may not have the best interest of the company in mind.

Disagreement

Just 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 Ds” can easily be planned for, but without a formal agreement, the “four Ds” 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.

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[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Resolving Shareholder Disputes and Understanding Risk Management Basics for Business Owners. This is an updated version of an article originally published on September 18, 2018.]

 

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