Bill is a part-owner and practitioner at a local medical practice, which he and his partner have been running for over 10 years. Bill’s partner has recently become fully disabled and is no longer able to participate in the practice. Although he would like to sell his ownership interest in the business, there is no buy sell agreement in place and Bill’s partner does not have the cash flow to purchase the shares outright. Additionally, they are having difficulty finding a suitable partner to bring into the practice, who must be a medical practitioner to buy in.
Situations like this on can arise quickly and can be a devastating blow to a small business. In fact, only about 15% of family owned small-businesses actually pass their businesses along to the next generation. A buy-sell agreement can ensure that you and your business partners have answers to questions that arise in scenarios similar to that above, like who will buy your shares in the business and for how much.
Key Points
- A buy-sell agreement is a legally binding contract that stipulates how an owner’s share of the business will be treated should the owner leave the business.
- There are many benefits to a buy-sell agreement, like having a set value or formula to calculate a value for the business and a process to make the transaction smoother.
- You may consider having a buy-sell agreement to create an exit plan, reduce valuation disagreements, or to have buyer(s) in place prior to selling the business.
- You need to engage a competent attorney well-versed in business succession planning to help draft your buy sell agreement.
What is a Buy-Sell Agreement?
A buy-sell agreement is a binding agreement between parties that establishes how an individual’s share of the business will be handled upon various events, like retirement, disability, or death. These are most commonly used in partnerships, closely held corporations, and solely owned businesses where shares of the company cannot be easily bought or sold.
A buy-sell agreement generally outlines the events which will trigger the sale of one’s ownership in the company, as well as who will be responsible for purchasing the shares. Additionally, it will outline the value of each member’s share of the business prior to the sale ever taking place, and (ideally) how the purchase will be funded.
You may still be wondering how a buy-sell agreement can benefit you and your business. Here are some of the reasons you might consider creating a buy-sell agreement.
Why Should I Have a Buy-Sell Agreement?
There are a number of reasons to have a buy-sell agreement put in place for your business. Many scenarios can play out that would lead to a partner leaving the business, such as retirement or disability. Since these scenarios can happen at any moment for a number of reasons, you may want to have a plan locked in place that outlines how the business will proceed for the future.
1. There is an agreed upon value or formula to arrive at a value
A buy-sell agreement includes an agreed upon market value of the business, and each owner’s share of the business, and outlines the price at which the sale will take place. With the price locked in before you or your partner are ready to sell, it reduces the risk there will be disagreements regarding the value at the time of the sale.
Additionally, because there is an agreed upon price for the sale, you know exactly how much you should plan to pay if the time comes. This can help you arrange your personal finances in a way that will allow for the purchase while keeping flexibility in mind.
Alternatively, some companies elect to outline a formula that will be used to calculate the future value of the business. While this may help a seller maximize their value (assuming the value increases over time, it can be hard to plan for as a buyer as your purchase price becomes a moving target.
Looking to maximize your business value? Read this: Boost your Business Value: Know Your Numbers
2. The parties are listed and legally bound
A main benefit of a buy-sell agreement is that the parties involved in the sale are pre-determined and legally bound to the agreement. You can be confident that you have a buyer of your shares ready for when you would like to retire, or for an unfortunate situation like disability. These parties are legally bound, meaning they can’t back out of the purchase, unless for a reason specifically identified in the agreement.
You can also be sure that your share of the business is going to who you want, like family members or your existing partner. This also ensures that your shares don’t go to someone you don’t want buying your shares, which could happen if you don’t have a formal succession plan in place.
3. It creates an exit plan
Without an agreement in place, you may be left wondering how you will exit your business, and who will take over when you’re gone. A buy-sell agreement lets you plan ahead by determining who will buy your share of the business and for how much, allowing you to focus on what matters.
This can also make it an easier transition for you and your business when you decide to leave. A buy-sell agreement can stipulate how long you may engage with the business after the sale, allowing you to ensure the new owners understand the operations of the business.
4. There is a plan for the unexpected
Unforeseen circumstances can be devastating for your business if they leave you, or another owner, unable to contribute for an extended period of time. A buy-sell agreement ensures that your business has a plan for various scenarios that may otherwise be crippling, like the total disability of an owner.
5. It can improve the stability of a business
A buy-sell agreement can be drafted to handle a business partner’s divorce, bankruptcy, or simply the desire of a partner to exit the business. This may improve the stability of the business for minority shareholders, key employees, and clients.
Things to Consider When Drafting a Buy-Sell Agreement:
Despite the numerous benefits of a buy-sell agreement, it is important to understand your personal situation and how a buy-sell can fit into your finances and your business situation. Here are some things to consider when thinking about implementing a buy-sell agreement.
1. Who will purchase your share of the business?
One of the most important decisions you must make prior to entering into a buy-sell agreement is who will purchase your shares of the business. Often, the buyer is an existing partner, family member, or another individual who is willing and able to take over the business.
However, there may be some restrictions and/or obstacles to who can buy your business. For example, if you are a healthcare professional, like a physician, you may be required to sell to another licensed physician. You should also consider what licenses, if any, the buyer should have to perform the duties of the business legally and successfully. Since it may be difficult or costly to acquire the required licenses, you may want to consider selling to someone who already has those licenses.
2. How will you fund the purchase of a partner’s shares?
Buying your partner’s share of the business can easily cost hundreds of thousands of dollars, or more. It is important that you determine how to fund the purchase prior to entering into a binding contract. There are a number of ways to fund a buy-sell agreement, like life insurance or an installment sale, but not all of them may be suitable for you.
3. What is the value of the business?
Often, determining the value of your business will depend on the type of business you have. There may be some form of industry standard regarding the value of your business, however, rules of thumb often do not apply without allowances. This can be a complicated process, so it is important to include professionals who understand your business and the market landscape. Your team will be broad-based and may include an attorney, a CPA or valuation specialist, a financial planner, and an insurance agent.
In valuing your business, it is important to understand how your value within the business will affect the potential sale of your business. The value of the sale can directly affect you and your partner’s ability to fund the buy-sell agreement, and it may also impact other aspects of your personal finances, like taxes.
Don’t leave decisions like this up to midnight googling sessions or once a year conversations with your CPA. Protect what you’ve worked so hard for and hire a fiduciary financial advisor.
The most important action for you to take is to get started. Schedule a complimentary call with us to discuss the possible ramifications of your buy-sell agreement and how you can avoid unwanted outcomes.
Thank you to Bryce Thompson for writing this article on behalf of the Spark Financial Advisors team.
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