Buyout Agreement: Everything You Need to Know
A buyout agreement is a binding contract between business partners that discusses buyout details when one partner decides to leave a business.4 min read updated on February 01, 2023
Updated October 26, 2020
Also known as a buy-sell agreement, a buyout agreement is a binding contract between business partners that discusses buyout details when one partner decides to leave a business. It lays out in-depth information on the determinable value of the partnership and who can purchase ownership interests. A buyout agreement also states the terms for departure from the business, if a buyout of the withdrawing partner is mandatory, and what may cause a buyout to happen. Aside from partnerships, corporations, LLCs, and S companies all can use buyout agreements.
Reasons for a partner leaving a business include divorce, death, bankruptcy, lack of interest, or mutual reasons between partners. Because a buyout agreement is a legally binding document, it can stand alone. Partnership agreements can also include a section or an addendum that constitutes a buyout agreement.
However, there are some common misconceptions about buyout agreements. While such agreements deal with partnership valuation, what happens when a partner exits the business, and who can purchase the partner's share, it is not used to tackle financial and tax issues. It does not manage the offering or purchasing of the partnership when it dissolves. Furthermore, a buyout agreement can also restrict a partner's ability to offer or exchange business ownership without the approval of other business owners.
Common Withdrawal Events Covered in a Buyout Agreement
There are several normal events, as well as irregular instances, that can spur a partner's withdrawal from the business. Any potential event should be covered in the buyout agreement. Some of the events that require a buyout agreement include:
- Divorce: In some divorce settlements, a partner's ex-spouse may receive all or some controlling interest in the partnership. This means the partner could try to purchase his or her former spouse's share in the business or sell his or her interest to the spouse or other partner.
- Debt or Bankruptcy: If a partner has a foreclosure of debt or an unpayable outstanding balance, a buyout agreement determines the steps necessary to sell his or her interest. This may enable him or her to pay down his or her debt without adversely affecting business operations.
- Death or Disability: If a partner becomes unfit to do the job or passes away, this may cause a buyout of his or her interest. Death may require the deceased's family to sell the share they inherit.
- Retirement or Resignation: In both of these instances, the partner has relinquished his or her interest in the business. The buyout agreement allows the remaining partner to maintain the business without further complications. In the case of retirement, the buyout agreement may list a specific age for a buyout to occur.
- Termination: In companies with multiple business partners or a corporation, the termination of one of the controlling partners can trigger a buyout. In some instances, the buyout agreement can restrict the terminated employee from offering his or her portion of the company back to the other investors for profit. It may also limit how the terminated partner may discuss industry secrets or other information with competitors or other individuals.
Reasons to Consider a Buyout Agreement
A buyout agreement protects the remaining business partner from financial hardship or legal questions when one of the partners leaves the business. Businesses have a 70 percent failure rate, making a buyout agreement all the more important. Without this document, the dissolution or separation of business may wind up in a lengthy and costly legal battle.
What makes the buyout agreement beneficial is that it's a legally binding document that both partners agreed to when the partnership formed. It should entail:
- A partner wants to set up a new business venture in a different location.
- Who can invest in the vacant portion of the partnership.
- Buyout valuations.
Buyout valuations are perhaps the most important aspect of a buyout agreement. This is typically the cause of most arguments during a buyout. Valuations are often regarded as the fair market value of the business as determined by a professional such as an accountant. Fair market value for a share includes factors such as:
- Shareholder loans
- Unpaid earnings
- Owed profits
To protect the remaining business partner, the buyout agreement should lay out restrictions for the departing business partner. Many buyout agreements have non-compete disclosures. This keeps the departing partner from developing relationships with previous clients or opening up a similar business within a certain geographic area or time frame. Buyout agreements may also limit a situation where a partner leaves simply for financial gain.
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