Buy-Sell Agreements: Protecting Your Business When Ownership Changes
When you build a business with one or more partners, you may spend years developing the company, increasing its value, and creating a successful operation together.
But what happens if one owner dies, becomes disabled, retires, or decides to leave the business?
Without a clear plan, an ownership change can create significant financial and operational problems.
A buy-sell agreement can help establish what happens to an owner's interest when certain events occur. When properly structured, it can help protect the business, the remaining owners, and the departing owner's family.
Life insurance can also play an important role by providing funding for a buy-sell agreement after an owner's death.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding agreement that establishes rules for transferring ownership interests in a business when specific triggering events occur.
Depending on the agreement, triggering events might include:
Death
Disability
Retirement
Voluntary departure
Involuntary termination
Divorce
Bankruptcy
Certain ownership disputes
The agreement can establish who can or must purchase an owner's interest, how the interest will be valued, and how the transaction will be funded.
Despite the name, a buy-sell agreement isn't necessarily a traditional "sale" between unrelated buyers and sellers.
It is often a business continuity and ownership planning tool.
Why Do Business Owners Need a Buy-Sell Agreement?
Without an agreement, an owner's death or departure can leave everyone uncertain about what happens next.
Imagine a company has three owners.
One owner unexpectedly dies.
Their ownership interest may become part of their estate and eventually pass to their spouse, children, or other beneficiaries.
Those heirs may not have any interest in operating the company.
At the same time, the surviving owners may not want to run the business with people who have never been involved in its operations.
A buy-sell agreement can establish a predetermined process for handling the ownership interest.
What Happens Without One?
Without a properly drafted agreement, business owners may face questions such as:
Who controls the company?
Who owns the deceased owner's shares?
Can the family sell the ownership interest?
How much is the business worth?
Who will purchase the interest?
Where will the money come from?
Can the remaining owners afford the purchase?
What happens if owners disagree?
These issues can create conflict at an already difficult time.
A buy-sell agreement attempts to address these questions before a triggering event occurs.
How Does a Buy-Sell Agreement Work?
The agreement generally establishes rules for what happens when an owner experiences a defined triggering event.
For example, a death-triggered agreement might provide that:
An owner's death triggers the agreement.
The deceased owner's interest must be offered or sold according to the agreement.
The business or remaining owners purchase the interest.
The deceased owner's estate receives the purchase price.
Ownership transfers to the remaining owners or another designated party.
The exact structure depends on the business and the agreement.
Common Types of Buy-Sell Agreements
There are several common structures.
Cross-Purchase Agreement
In a cross-purchase arrangement, the individual owners agree to purchase the ownership interest of an owner who dies or experiences another triggering event.
For example, if three owners each own one-third of a company, the remaining two owners could purchase the deceased owner's interest according to the agreement.
Life insurance can potentially be used to fund the purchase.
Entity-Purchase Agreement
An entity-purchase agreement, sometimes called a redemption agreement, allows the business itself to purchase the departing owner's interest.
For example, if an owner dies, the company may purchase the deceased owner's ownership interest from their estate.
The remaining owners' percentage ownership may increase after the transaction.
Hybrid Arrangements
Some businesses use arrangements that combine elements of cross-purchase and entity-purchase structures.
The appropriate structure can depend on the number of owners, business entity, tax considerations, ownership goals, and other circumstances.
How Does Life Insurance Fund a Buy-Sell Agreement?
One of the biggest challenges with a buy-sell agreement is determining where the purchase money will come from.
Life insurance can potentially solve part of that problem.
Consider a business with two equal owners.
Each owner's interest is valued at $1 million.
The owners establish a buy-sell agreement requiring the surviving owner to purchase the deceased owner's interest.
Each owner purchases life insurance on the other.
If one owner dies, the surviving owner may receive the life insurance death benefit and potentially use those proceeds to purchase the deceased owner's business interest.
This can provide liquidity when it's needed most.
Why Funding Matters
A buy-sell agreement without adequate funding can be difficult to execute.
Suppose a deceased owner's interest is worth $2 million.
The surviving owners may not have $2 million in cash available.
They might otherwise need to:
Borrow money
Sell investments
Liquidate business assets
Negotiate installment payments
Take on significant debt
Life insurance can potentially provide the cash needed for the transaction.
The actual funding structure should be coordinated with the agreement and reviewed by appropriate legal and tax professionals.
What Happens to the Deceased Owner's Family?
A buy-sell agreement can potentially benefit the deceased owner's family as well as the remaining business owners.
The family may receive financial compensation for the owner's business interest rather than inheriting an ownership position they don't know how to manage.
For example, instead of the owner's spouse inheriting a 50% interest in a company they have never worked in, the agreement could provide for the interest to be purchased and the estate to receive the agreed-upon value.
This can create a cleaner separation between business ownership and family inheritance.
How Is the Business Valued?
One of the most important parts of a buy-sell agreement is determining how the business will be valued.
Possible approaches include:
A predetermined value
A valuation formula
An independent appraisal
A multiple of revenue
A multiple of earnings
A combination of methods
The agreement should clearly explain how the value will be determined.
A business may be worth substantially more when an owner dies than it was when the agreement was originally signed.
That's why valuation provisions should be reviewed regularly.
What If the Business Value Changes?
Imagine a company is worth $1 million when the buy-sell agreement is created.
Ten years later, the company is worth $5 million.
If the agreement still uses the original $1 million valuation, the ownership interest may not be priced according to the company's current value.
This can create significant problems for both the departing owner's family and the remaining owners.
Business owners should therefore periodically review:
Company valuation
Insurance coverage
Ownership percentages
Funding requirements
Valuation methods
Buy-Sell Agreements for Different Business Structures
Buy-sell planning can be relevant to:
Partnerships
LLCs
S corporations
C corporations
Family-owned businesses
Professional practices
The legal and tax implications can differ depending on the business entity.
For example, transferring ownership interests in an LLC can involve different considerations than transferring shares of a corporation.
Your attorney and tax professional can help ensure the agreement is appropriate for the structure of your business.
What Events Should Trigger the Agreement?
Death is one of the most common triggering events, but it doesn't have to be the only one.
A comprehensive agreement may address:
Death
What happens when an owner dies?
Disability
What happens if an owner can no longer work?
Retirement
How will an owner exit after reaching retirement?
Voluntary Sale
What happens if an owner wants to leave?
Involuntary Sale
What happens if an owner must leave the business?
Divorce
Could an ownership interest become subject to a divorce proceeding?
Bankruptcy
What happens if an owner's creditors become involved?
Addressing these situations in advance can reduce uncertainty.
Buy-Sell Agreements and Life Insurance Are Different
It's important to understand that life insurance does not replace a buy-sell agreement.
The agreement establishes the rules.
The life insurance can potentially provide the funding.
Think of them as two parts of the same strategy:
Buy-sell agreement: Determines what happens.
Life insurance: May provide money to help make it happen.
Both should be coordinated carefully.
How Much Life Insurance Is Needed?
The amount of coverage should generally be connected to the value of the ownership interest and the obligations established by the agreement.
For example, if an owner's interest is worth $1 million, the business owners may consider whether approximately $1 million of coverage is appropriate for the intended transaction.
But the appropriate amount can change as the business grows.
Coverage should be reviewed periodically to make sure it remains aligned with the company's current valuation and ownership structure.
Common Mistakes Business Owners Make
Some common problems include:
Creating an agreement and never reviewing it
Failing to fund the agreement
Using outdated business valuations
Not addressing disability
Ignoring tax considerations
Failing to update beneficiaries
Not coordinating insurance ownership with the agreement
Assuming the business value will remain constant
Failing to communicate the plan to relevant parties
A buy-sell agreement is only useful if it reflects the business as it exists today.
Questions Business Owners Should Ask
Consider asking:
What happens if an owner dies?
Who will own their interest?
Who has the right or obligation to purchase it?
How will the business be valued?
How will the purchase be funded?
Is life insurance appropriate?
Is the insurance coverage sufficient?
What happens if an owner becomes disabled?
What happens if an owner retires?
What happens if an owner wants to sell?
How often should the agreement be reviewed?
Does the agreement match our current ownership structure?
The Bottom Line
A business can take years to build, but an ownership transition can happen unexpectedly.
A buy-sell agreement can help business owners establish a clear plan for what happens when an owner dies, retires, becomes disabled, or otherwise leaves the company.
When combined with appropriately structured life insurance, a buy-sell agreement can potentially provide both a clear ownership transition plan and the financial resources needed to execute it.
The strategy can protect the remaining owners while also helping provide fair value to a departing owner's family or estate.
Don't wait until a business partner dies or leaves the company to decide what happens to their ownership interest.
Creating the agreement while everyone is healthy, involved, and working toward the same goals can make the process significantly easier.
For business owners, a buy-sell agreement isn't simply about planning for the end of an ownership relationship. It's about protecting the business you've built and giving the people who depend on it a clear path forward.