Structuring a Buy-Sell Agreement: Key Considerations for Business Owners

A well-drafted buy-sell agreement is a cornerstone of business continuity, especially for small business owners who share ownership with partners. According to the Exit Planning Institute, over 70% of small businesses do not have a formal exit plan, which includes buy-sell agreements, despite the fact that 60% of business owners intend to exit their business within the next decade. These agreements are essential for outlining the terms under which ownership stakes can be transferred, ensuring that unforeseen events do not disrupt the operations or valuation of the business. Without a clear buy-sell agreement, businesses are at significant risk of operational disruptions, legal disputes, and financial instability in the event of an owner’s departure or other triggering events.

What is a Buy-Sell Agreement?

A buy-sell agreement is a legally binding document that outlines how a partner’s share of a business may be reassigned if that partner dies, becomes disabled, retires, or otherwise exits the company. It can also cover situations such as divorce, bankruptcy, or a disagreement among owners. By establishing clear terms for buyouts, these agreements help maintain business stability and prevent disputes among remaining partners or with the departing partner’s heirs.

Types of Buy-Sell Agreements

1. Cross-Purchase Agreement: In a cross-purchase agreement, the remaining owners of the business buy the departing owner’s shares. This type of agreement is often suitable for businesses with a small number of owners. Each owner purchases a life insurance policy on the others, and the proceeds are used to buy the shares of a deceased or otherwise departing partner. This arrangement keeps the business ownership within the existing group and avoids external involvement.
2. Entity Purchase (Redemption) Agreement: Under an entity purchase agreement, the business entity itself buys the departing owner’s shares. This type is typically easier to manage with multiple partners since the business holds one policy per partner, and the buyout is executed through the company. However, it can lead to tax implications for the remaining owners and may affect the company’s cash flow or credit lines.
3. Wait-and-See Agreement: A wait-and-see agreement combines elements of both cross-purchase and entity purchase agreements, allowing flexibility based on circumstances. Initially, the business has the option to purchase the departing owner’s shares. If the business declines, the remaining partners can buy the shares instead. This type offers maximum flexibility but requires careful drafting to ensure it meets legal and financial requirements.
4. Hybrid Agreement: A hybrid buy-sell agreement incorporates aspects of the other types and can be tailored to meet the specific needs of the business and its owners. For example, the agreement might stipulate that a certain percentage of the buyout is conducted through an entity purchase, while the remainder is handled via cross-purchase.

Key Considerations in Structuring a Buy-Sell Agreement

Triggering Events: The agreement should clearly define the events that would trigger a buy-sell provision, such as death, disability, divorce, retirement, or voluntary departure. Ensuring clarity on these triggers helps prevent ambiguity and conflict.

Funding Mechanisms: Funding the buyout is a critical aspect of buy-sell agreements. Options include life insurance, company reserves, installment payments, or third-party loans. Life insurance is commonly used to cover the cost of buyouts due to death, while disability buyout insurance can provide liquidity if an owner becomes disabled.

Valuation Methods: Accurately valuing the business is crucial in buy-sell agreements. The chosen valuation method can significantly impact the buyout price and, consequently, the financial stability of both the business and the departing owner’s beneficiaries. A study published in the Journal of Business Venturing emphasizes the role of accurate business valuation in protecting shareholder interests and preventing conflicts during ownership transitions (Smith, 2020). Businesses with well-structured valuation terms in their buy-sell agreements experienced significantly fewer disputes compared to those with ambiguous or outdated valuation methods.

Valuation Methods for Buy-Sell Agreements

1. Fixed Price Method: The fixed price method involves the owners agreeing on a set price for the business or each owner’s share. This amount is typically reviewed and adjusted periodically. While simple and straightforward, this method can become problematic if the business’s value fluctuates significantly, as it may not reflect current market conditions. Data from the National Association of Certified Valuators and Analysts (NACVA) indicates that 58% of business owners found the valuation terms in their agreements inadequate or outdated when a triggering event occurred (NACVA, 2021), highlighting the need for regular updates.
2. Formula Method: The formula method sets a valuation based on a predetermined formula, such as a multiple of earnings, revenues, or book value. This approach provides a more dynamic valuation than the fixed price method but can still present challenges if the formula does not adequately capture the business’s market value or if industry conditions change. The Harvard Business Review has noted that valuation formulas, while helpful, can lead to disputes if they fail to keep pace with the business’s growth or changes in the market environment (Jones & Matthews, 2019).
3. Appraisal Method: The appraisal method relies on an independent third-party valuation at the time of the triggering event. This approach is generally considered the most accurate, as it reflects the business’s market value at the time of the buyout. However, the appraisal process can be time-consuming and costly, and differing appraisals may lead to disputes. A properly executed appraisal method reduces conflicts by providing a current and objective valuation, as supported by industry studies showing that independent appraisals often lead to smoother transitions (Smith, 2020).
4. Market-Based Valuation: Market-based valuation involves assessing the value based on comparable sales of similar businesses. This method is useful in industries with active markets for comparable businesses but may be less effective in niche markets or for businesses with unique characteristics. Research shows that market-based valuations are highly reliable in well-established industries but can be misleading in volatile or emerging markets, necessitating adjustments or alternative valuation approaches (Smith, 2020).
5. Book Value: Book value considers the company’s net asset value as recorded on the balance sheet. While this method is straightforward and easily understood, it may not capture the true market value of a business, especially for companies with significant intangible assets like goodwill, intellectual property, or a strong brand. The NACVA survey (2021) revealed that businesses relying solely on book value often face challenges during buyouts, as book value can significantly undervalue companies with robust intangible assets.
6. Discounted Cash Flow (DCF): The DCF method projects the business’s future cash flows and discounts them to present value using a discount rate that reflects the business’s risk. This method is often regarded as the most accurate for valuing a going concern but requires robust financial projections and assumptions, which can be contentious. Studies have shown that DCF provides a comprehensive valuation by incorporating future performance expectations, making it a preferred choice among professional valuators (Smith, 2020).

Practical Tips for Small Business Owners

1. Engage Professional Advisors: Work with experienced legal, financial, and valuation professionals when drafting your buy-sell agreement. Their expertise can help ensure that the agreement reflects the unique needs of your business and its owners.
2. Regularly Review and Update: Business values and circumstances change over time. Regularly review and update your buy-sell agreement to ensure it remains relevant and accurate. Consider setting annual or biennial reviews as part of your business planning process.
3. Consider Tax Implications: Different buyout structures and funding mechanisms can have varying tax implications for both the business and individual owners. Consult with a tax advisor to understand these implications and structure the agreement to minimize tax liabilities.
4. Ensure Adequate Funding: A buy-sell agreement is only as effective as the funding mechanism behind it. Evaluate your options, including life insurance and company reserves, and ensure that funds will be available when needed.
5. Plan for Dispute Resolution: Include provisions for dispute resolution in your buy-sell agreement. Whether through mediation, arbitration, or another method, having a clear path to resolving disagreements can save time, money, and relationships.

Conclusion

A well-structured buy-sell agreement is vital for small business owners who wish to safeguard their company’s future and ensure a smooth transition of ownership. By carefully considering the type of agreement, funding options, and valuation methods, business owners can create an agreement that meets their needs and protects their interests. Regularly revisiting and updating the agreement ensures that it continues to reflect the business’s current value and ownership structure, providing peace of mind for all involved.

For assistance in drafting or reviewing a buy-sell agreement, contact our expert team at Miller Edwards Rambicure. We specialize in business law and are committed to helping you navigate the complexities of ownership agreements with confidence and clarity.