Plan Ahead with a Buy-Sell Agreement

Of all the pitfalls small business owners confront, few are as traumatic as the loss of a co-owner. When two or more individuals open a business together, the retirement or death of one of them may be the furthest thing from their minds. Yet, planning early on for such possibilities can help ensure continuity of the business and provide financial security for departing owners and their families.

That’s where a legal contract known as a "buy-sell agreement" comes into play. Buy-sell agreements lay out how ownership will change hands and how the transfer will be paid for in case of a co-owner’s death, disability or retirement. If you operate your business as a corporation, the buy-sell agreement is usually a separate document. In most cases, it will provide for the purchase of the departing shareholder’s stock by the surviving shareholders or the company itself.

Buy-sell agreements can serve several valuable purposes. These include:

•Retaining Control: prevents stock sales to new shareholders without the approval of the remaining ones, thus assuring surviving shareholders that no unwanted outsiders will buy into the company. This also allows an orderly continuation of the business.

•Guaranteed Market: creates a ready buyer for the stock at a fair price, thus avoiding a forced sale by the deceased shareholder’s heirs.

•Source of Funds: depending on how the agreement is funded, it can provide cash to the selling owner (or his or her heirs) to meet living expenses and estate settlement costs.

•Tax Considerations: provides an opportunity for income tax and estate tax planning.

A buy-sell agreement should name the various events that would trigger a change of ownership—most commonly, death, disability, retirement or divorce. It should also specify who has the right to buy the stock from a departing shareholder. The agreement must also stipulate how the business will be valued, and where the money will come from to fund the buy-out.

Life insurance is a widely used means of funding the purchase of stock after the death of an owner. If one owner dies, the proceeds from the policy, which is owned by the other owner or by the business itself, are used to buy the shares from the deceased owner’s estate. In the event of a shareholder’s extended disability, lump sum disability policies are also available to fund a buy-out. In cases where an owner retires, the buy-out may be financed with the company’s cash reserves or future operating revenue, and may be paid over time.

The two basic types of corporate buy-sell agreements are a "cross-purchase agreement" and a "stock redemption agreement."

Each of these two types of stock buy-sell agreements can be used to provide a solution in a given situation involving the loss of a key shareholder in small, closely-held companies.

•Cross-purchase Agreement. This is a buy-sell agreement among stockholders under which they agree to buy each other’s stock upon certain triggering events. Assume, for instance, that a corporation has two stockholders, A and B. A and B each agree that, upon the death of one of them, their estates must sell, and the survivor must buy, the stock.

•Stock Redemption Agreement. This is a buy-sell agreement among the corporation and the stockholders that obligates the corporation to buy the departing owner’s shares. Using the above example, the corporation would agree to buy the shares of both A and B at death.

Each type of agreement has pros and cons. With a cross-purchase agreement, the stockholders typically buy life insurance policies on each other to finance the purchase.

That’s relatively simple with just a few owners. But if there are several shareholders, multiple policies would have to be bought –adding a level of complexity. In that case, a redemption agreement may be preferable. This is just one of many factors that must be considered.

A properly drafted buy-sell can help put your business succession plan into focus. Selecting the right type of agreement for your business will involve a careful analysis of your goals and the particular circumstances facing your company.

Seek the guidance of a professional financial adviser to better understand what type of buy-sell makes sense for you.