A buy/sell agreement governs how, when, and why partners/owners leave a business, as well as other types of events. A partner’s interest in the business is an asset, and assets are affected at death, divorce, and bankruptcy. As a business owner, you do not want a partner’s death, divorce, or bankruptcy to detrimentally impact the business, right? All of these contingencies can be planned for in advance. We typically encourage our clients to incorporate these provisions in their partnership or operating agreement right from the very beginning, but the buy/sell agreement can be a stand-alone contract.
There are a lot of decisions to be made when going into business with others—naming your business, marketing, capital and profit sharing arrangements, etc. Unfortunately, partners do not always think about the end game, which is exiting the business. Maybe there is a disagreement between the owners as to the future of the company. One partner may want to sell while another doesn’t. If one owner wants to sell just their interest and retire, do the other owners have any say to whom the owner sells to? Should the other owners get the option of purchasing the interest first? If a partner passes away, a family member could inherit their interest, leaving an unsophisticated person running the business with you. Even worse is divorce—during the equitable distribution of a couple’s finances, an ex-spouse could become part owner of a business or force the sale of the spouse’s interest.
Another important concept that many people overlook is how they are going to be able to afford buying another partner out. Oftentimes, having that much cash on hand is impossible. An installment payment plan can be provided for in the buy/sell or operating agreement. To protect against death, life insurance policies are a great way to fund the buyout of a partner who has passed away. The company or the other owners buy policies for each other (but not themselves), and upon the death of a member, the company or owners receive the life insurance benefit. That money can be paid to the family of the deceased as payment for his or her interest in the business.
Finally, buy/sell or operating agreements can stipulate the type of valuation that should be used if and when an ownership interest is sold. There are three main types of business valuation methods: Asset Approach, Market Approach, and Income Approach. Even if business owners agree on who should purchase the interest, if they haven’t previously agreed upon the valuation method, the owners could come up with different valuations and be forced to file a lawsuit and have the court decide.
In the event that business owners have not planned for these almost-certain future events, depending on the terms of the operating agreement, a court can force the dissolution of a business. Many business owners avoid hiring attorneys because of the cost. However, it is important that business owners consider the comparatively small cost of hiring an attorney to assist them with these matters now, as the future cost could be much, much higher, and their business could suffer or be forced to close as a result.
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Kelly Rains Jesson