What Should Business Owners Know About Creating a Buy-Sell Agreement?

What Should Business Owners Know About Creating a Buy-Sell Agreement?

You have spent years building your business, but have you established a plan for its future? A buy-sell agreement serves as a critical buffer, helping your business transition smoothly during unexpected life events rather than falling into chaos. At Prosper Financial, we specialize in helping clients navigate the complexities of succession planning. By creating a comprehensive buy-sell agreement, we help you preserve the value of your hard work and provide clarity for your partners, employees and family members.

Business owners should carefully consider the significance of a buy-sell agreement:

• Continuity: Buy-sell agreements prevent disruption during ownership transitions.
• Clarity: They clearly define triggering events, such as retirement or disability.
• Fairness: Predetermined valuation methods reduce the risk of disputes.
• Liquidity: Proper funding strategies makes finances is available when needed.

What events trigger a buy-sell agreement?

A buy-sell agreement is activated by specific life events that impact an owner’s ability to remain involved in the business. Without a legally binding contract, the departure of a partner can lead to rushed decisions or disputes among heirs and co-owners. To support the continuity of the company, your agreement should clearly outline which scenarios kickstart the transfer of ownership. Common triggering events include:

• Death or disability: Safeguards the business if an owner passes away or becomes permanently incapacitated.
• Retirement: facilitating a planned exit strategy for aging owners.
• Divorce or bankruptcy: Prevents an owner’s ex-spouse or creditors from acquiring a stake in the company.
• Deadlock: Resolves situations where partners can no longer agree on the direction of the business.

By defining these triggers early, you can plan so that ownership interests are transferred according to your terms, not dictated by external circumstances.

How is business value determined in the agreement?

The agreement must establish a specific method for calculating the company’s worth to mitigate conflict during a buyout. Disagreements over price are a primary source of friction during business transitions. A robust buy-sell agreement mitigates guesswork by setting a valuation mechanism in advance. This is possible through one of three methods:

1. Fixed Price: The owners agree on a specific dollar amount, which is updated periodically.
2. Formula Approach: The value is calculated based on financial metrics, such as a multiple of earnings or book value.
3. Professional Appraisal: An independent third party determines the fair market value at the time of the triggering event.

Regardless of the method chosen, having a defined approach helps avoid future friction and allows the departing owner (or their family) to receive fair compensation.

What are possible ways to fund a buyout?

For a buy-sell agreement to be effective, the funds must be readily available to purchase the departing owner’s shares. Even the most detailed agreement fails if the capital isn’t there to execute it. Creating a funding strategy is just as important as drafting the legal terms. Business owners can utilize a few key methods for liquidity:

• Life Insurance: This is a common strategy where policies are purchased on the lives of each owner, providing a financial buffer in the event of death.
• Financial Reserves: The company sets aside retained earnings over time to cover potential buyouts.
• Loans: The business or remaining partners secure bank financing to pay for the shares.
• Installment Payments: The purchase price is paid out over time, reducing the immediate financial strain on the company.

Structuring these payments correctly is essential. For example, in a Cross-Purchase Agreement, partners buy insurance on each other, whereas in a Redemption Agreement, the business itself holds the policies.

How often should you review your buy-sell agreement?

You should review your agreement every few years or immediately following any major business change. A buy-sell agreement is not a “set it and forget it” document. As your business grows, its value increases, tax laws shift and personal dynamics change. An agreement created five years ago may rely on outdated valuations or fail to account for new partners. Failing to update the document can lead to underfunded buyouts or tax complications. Review your plan alongside financial and legal professionals whenever you experience revenue growth, structural changes or shifts in your personal financial goals.

We Support your business’s future

Preparing for the unexpected is a hallmark of responsible business ownership. A well-crafted buy-sell agreement helps your business weather the loss of an owner without jeopardizing its financial health. Whether you are looking to conserve your family’s inheritance or support the longevity of your enterprise, Prosper Financial is here to help. Contact our office today to request a consultation and start building a comprehensive strategy for your future.