A buy-sell agreement protects the owners of a business from unintended consequences of a co-owner’s death, retirement, divorce or disability. Moreover, subject to certain exceptions, without a buy-sell agreement, the owners of a business may sell or transfer their business ownership interest (their “Interest“) without restriction.
First, a buy-sell agreement establishes:
• when the co-owners of a business can sell their Interest;
• the purchase price paid to a selling partner; and
• who is eligible to own, purchase or sell an Interest.
Second, buy-sell agreements provide a funding mechanism for the purchase or sale of an Interest. Many times life insurance is the source of funding. Also, the valuation method used to determine the business’ market value is defined. Valuation options include formulas such as book value, liquidation value or capitalization of earnings. Another valuation option is requiring an independent appraisal to establish the purchase price of an Interest.
Third, buy-sell agreements each have different purchasing requirements. Accordingly, some types provide for mandatory purchases by either the co-owners or the business entity upon a triggering event. Possible triggering events are death, disability or retirement of a co-owner. Other types of buy-sell agreements provide for optional purchase rights for co-owners. Optional purchase rights are used when the transfer of ownership is to a new partner or between existing partners.
There are three main types of buy-sell agreements:
Cross Purchase Agreement
A cross purchase agreement obligates the remaining co-owners of a business to purchase a departing co-owner’s Interest. The agreement sets a previously agreed price and determines the proportions of purchases between the co-owners. This type of buy-sell agreement does not contain an option for the business to purchase any of the Interest of the departing or deceased owner. In the event of a death of a partner, cross purchase agreements use the proceeds of life insurance to fund purchases and sales between partners and the deceased partner’s probate estate.
An entity redemption agreement obligates the business entity itself to purchase a departing co-owner’s Interest in the business. In the event of an owner’s death, the business uses life insurance it owns on the life the deceased co-owner to fund a purchase of the deceased owner’s Interest.
Mixed or Hybrid Agreement
A mixed or hybrid buy-sell agreement combines the cross purchase and redemption agreements. Both the business entity and the remaining co-owners have the right and/or obligation to purchase and sell Interests. The goal is to provide flexibility to the business and the co-owners upon a triggering event.
Additionally, for more information about closely held businesses see:
Also, for more information about buy-sell agreements see: