Before starting a business with others, it is crucial you draft a buy-sell agreement. Even for the simplest businesses, a buy-sell agreement can save it from future financial collapse. In fact, it might be the only written document you need. Learn why they are important and the top six things to consider when drafting one.
A Buy-Sell Agreement Benefits Everyone
Also known as a buyout agreement, a buy-sell agreement is a legally binding contract among multiple owners of a business that spells out what happens to an ownership interest in the case of various life-changing events. These events could include departure, death, divorce, disability, or retirement. Without an agreement in place, these events could trigger conflicts that ruin a company and bankrupt its owners.
Before Drafting a Buy-Sell Agreement
Before putting it together, think through these topics in order to best inform the buy-sell agreement:
- Insurance. Often, the main concern when a life event necessitates an exchange of shares is finding the cash to fund a buyout. Thus, talk about purchasing insurance policies to be able to get the money you need, especially in cases of death and disability.
- Objectives. Know the short- and long-term objectives for both your business and its owners. If individuals have widely different objectives, starting a business together and drafting a buy-sell agreement might not be possible.
- Taxes. Understand all tax consequences in the event shares are exchanged. This can save considerable amounts of money.
- Scenarios. Make sure to think through any and all worst-case scenarios to ensure you have all possible preemptive clauses that protect against such instances. You might not like to think about them, but even the strongest relationships can spoil.
Top 6 Buy-Sell Agreement Considerations
Once you’re prepared to start drafting a buy-sell agreement, here are the top six considerations you should address:
1. Picking Buyout Triggers. The main events that trigger buy-sell commitments are retirement, death, divorce, disability, and failing to meet an contractual requirement, such as a capital contribution. Make sure to stipulate clearly the consequences of a triggering event, and that potential sellers are assured their shares will be bought and potential buyers are not forced to buy shares they cannot afford.
However, depending on your business, some of these events might not need to trigger a buy-sell commitment. For example, if a specific owner is not essential for the survival of the business, it might be fine if she or he maintain ownership, or in the case of death, her or his shares simply pass to a spouse or surviving relative.
2. Common Buyout Clauses. Forbes magazine contributor Steve Parrish advises considering these clauses:
- Wait-and-see. Commits owners to a sale while deferring the specifics until a triggering event. Provided the owners trust each other, this flexibility can be bountiful from a tax and ownership perspective.
- Shotgun clause. Commits owners to a set share price in the case one owner wants to leave and sell all shares. This protects owners from a long, drawn-out court battle if one decides to leave the business.
- Drag-along provision. Commits minority owners to join a majority owner in any sale of shares. This protects majority shareholders from minority shareholders stopping any deals.
- Tag-along provision. Commits majority owners to let minority owners join any deals. This guarantees minority owners get the same terms as the majority owner for any sales.
3. Choosing the Right Buyer. If a shareholder is essential to business operations, the buyer of her or his shares must also be capable of filling her or his role. With a family-owned business, decide which family members will receive voting and non-voting interests to ensure control rests with those who can run the business well.
4. Setting the Purchase Price. Agreeing to a purchase price is often a contentious process. Thus, make sure you write procedures to settle price disputes quickly. This might be agreeing to purchase prices annually, or agreeing to a price set by an independent third party like an appraiser or arbitrator.
5. Adopting Balanced Buyout Terms. Even with a settled purchase price, businesses and buyers often default on payments. Think through reasonable interest rates, down payments, buyout periods, stipulations for low business cash flow and security guarantees. With small businesses, know these must usually favor the buyer. This is where understanding objectives really comes into play.
6. Selecting a Structure without Tax Surprises. The last thing you want to find after a sale is a large, unexpected tax payment. Thus, know which corporate structure will work best:
- S corporations can only hold interests in specific trusts, meaning would most likely be more tax-efficient for the buyer to directly buy out the seller.
- With regular corporations, however, it is generally more favorable if the corporation buys out the seller.
Find a financial advisor who specializes in corporate tax issues to appraise the buy-sell agreement maximizes all interests.
With buy-sell agreements, there are a lot of difficult conversations to have, and many complicated scenarios to think through. But doing that work will establish the trust and peace of mind necessary to grow a business and ensure its longevity.