Buy-sell agreement: Definition, types & purpose

When multiple people own a business together, they should plan for the possibility of someone leaving by choice or circumstance. A buy-sell agreement can protect your business interests by paving the path for a smooth transition, even in unexpected situations such as disability or death.

Establishing and funding a legal buy-sell agreement is a smart way to ensure you and your business aren't left scrambling if one of the owners wants out or if something happens to them.

A buy-sell agreement is a legally binding contract for joint business owners that establishes what happens to a co-owner's business interest if they leave the business, become incapacitated or die. The purpose of a buy-sell agreement is to protect the departing owner, the remaining owners, each of their families and the business itself.

With a buy-sell agreement in place, the remaining owners can be better positioned to continue operating the business, control who has ownership stakes, safeguard business assets, and potentially compensate a departing owner's family in the event of death or disability.

Buy-sell agreements should be part of your business succession plan so you can navigate these triggering events:

• If an owner wants to leave the business, a buy-sell agreement gives other stakeholders the chance to buy out that person's shares or business interests before they can be sold or given to anyone else.
• If an owner dies or becomes incapacitated, a buy-sell agreement lays out the plan for transferring their shares or business interests to the other owners or the business entity. These situations may include provisions for the family of a deceased or disabled owner to receive compensation when the circumstances of losing a stake in the business were beyond the owner's control.

Buy-sell agreements often include a funding aspect that creates a way for the other owners or the business to buy out a departing owner's interest when needed.

A buy-sell agreement can be made and modified at any time. Provisions even may be written into the business's governing documents. Because these agreements are contracts tailored to specific needs, it's best to have a professional help you create one.

As the agreement is drawn up, consider how the owners or the business would get the money to support the buy-sell terms. While you could plan on borrowing money or selling assets when the time comes, having planned funding equips you to buy out a departing owner's interests without taking on a financial burden or a loss.

The most common ways to fund a buy-sell agreement include:

• Insurance contracts. The owners or the business purchase life or disability insurance contracts for each owner. In the case of death or incapacitation, the insurance benefit payout can be used to fund the buyout.
• Cash reserves. The owners or the business may decide to put aside money in a banking or brokerage account so they can be ready to purchase a departing owner's interest outright.
• Installment notes. The owners or the business can plan to buy the departing owner's shares or other stake in the business a bit at a time by setting up regular payments.
  
• Sinking fund. With this method, some of the business's profits are held separately to be used only in the event of a buy-sell agreement triggering event.

There are two main kinds of buy-sell agreements: Cross-purchase and entity-purchase or stock redemption. The one you use for your business may depend on how many people are involved and how you want to fund the agreement.

With basic cross-purchase agreements, each owner establishes an interest in the other owners—often by purchasing a life or disability insurance contract on them. If one owner leaves, becomes incapacitated or dies, the agreements make it easy for the other owners to divide and acquire that person's business interest. If you have insurance contracts in place, the proceeds can be used for the purchase. Otherwise, the individual owners would need cash reserves or an installment plan (or they could borrow money or sell assets).

Because of the complexity of arranging contracts between each owner, this type of buy-sell agreement often works best when only a few stakeholders are involved.

Entity purchase or stock redemption agreements are similar to cross-purchase agreements except the business—rather than the other owners—is positioned to buy the business interest or redeem the shares held by the departing owner. The business entity may use insurance to fund this but could also use cash reserves, installments or a sinking fund (or it could borrow money or sell assets).

This type of buy-sell agreement often makes more sense when there are many owners or a corporate arrangement since the business will only need to have one contract for each owner.

Because they are legally binding contracts, your buy-sell agreement should detail the key elements and potential circumstances as much as possible. These include:

• Owners involved. Be sure to list not only the names of each owner but also the portion of the business they own.
• Funding methods. If you're planning on nurturing a way to have money on hand for a buyout when needed, such as insurance contracts or a special account, include that information in the agreement.
• Buyout events. Identify the specific situations the agreement will cover. In addition to death or incapacitation, consider all the reasons an owner may leave, such as retirement or not getting along with other owners.
• Company valuation. Many agreements lay out a method for determining how much the company and each owner's portion of it is worth to avoid conflicting calculations or opinions.

A buy-sell agreement can be a smart move for any business with more than one owner. In addition to other business continuity and succession tools—such as key person life insurance—it can be an effective way to protect the value of the joint business venture you and others have built.

A Thrivent financial advisor can partner with your attorney to help decide the best approach to a buy-sell agreement for your business.