Changes in small business ownership can be costly, and negatively impact the business. If you are in a small business partnership, you should establish a buy-sell agreement to pre-determine what will happen if one of the partners leaves the business. You may not anticipate that either of you will leave; however, death, divorce, changes in circumstance, a risky economy and other significant life events can all make one partner leave the business unexpectedly.
A buy-sell agreement is a legal contract (usually between the owners or partners of a company), that defines exactly how a partner (called a “departing partner”) can leave a company. Such a buy-sell agreement will identify how the value of the company is to be determined, and indicate how the remaining partners (or the company itself) will purchase the ownership interest of the departing partner. Buy-sell agreements differ from one company to the next, but all such agreements will address all the ways a partner could leave a company, including voluntary or involuntary departure, such as termination of employment, death and incapacity.
What are the benefits of creating a buy-sell agreement?
A buy-sell agreement can lessen uncertainty during a partnership change, and therefore reduce costs and emotional stress (especially during a traumatic event). The agreement can determine:
- A valuation formula, or fixed price, to establish the value of a partner’s ownership interest
- Whether a partner can be bought out
- The terms of the purchase payment process
- Who can buyout a partner’s ownership
- When a buyout is triggered
Some events that can trigger a buyout include: partner death, incapacity, bankruptcy, retirement or a third-party offer.
A buy-sell agreement will help the business avoid costly litigation in determining the value of ownership interests and deciding who can purchase the ownership interests. If you do not determine who can buy a partner’s ownership interests, you may be stuck in a business deal with a new undesirable business partner, such as a family member of a deceased partner.
What types of buy-sell agreements are there?
You can set up a cross-purchase agreement or redemption style agreement or a hybrid of the two. A cross-purchase agreement allows one partner to buy the other business partner’s share. In a redemption style agreement, the business itself purchases the departing partner’s ownership interest. This agreement ensures that the purchasing partner (or company) is financially able to afford the ownership interests of the departing owner — it in the cases of a death or incapacity, that the family or estate of the departing partner is taken care of.
Consider key-man or key-life insurance for the partners, to help fund certain contingencies.
Contact an attorney if you are interested in creating a buy-sell agreement, or reworking an existing agreement’s terms. It may seem like a hassle to create a legal agreement, but a buy-sell agreement can save you a lot of time, money and stress in the future.
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