What is a Buy-Sell agreement?
A buy-sell agreement is a legally binding contract between business co-owners that govern how the shares of a co-owner in the business can be reassigned in the event of death or the business’s departure. It is also referred to as a buyout agreement or a business will.
Financial planners and business-succession specialists recommend having the buy-sell agreement insured so that there is guaranteed to be enough funds if the buy-sell gets triggered.
The event is triggered when the co-owner dies, exits voluntarily, or is forced to leave the business by the other shareholders. The business partners should engage both a certified public carmel accountant and an attorney for buy-sell agreement crafting.
This formal agreement is a business continuity tool that provides a road map for an exit strategy of a co-owner to ensure that business does not get disrupted or have value hurt. It allows the owners to know who stands to buy into the business, and how they will go about the process
Key Features of a Sound Buy-Sell Agreement
An agreement at a point in time.
For a buy-sell agreement to hold, there must be an agreement between a company’s shareholders and the company, which is evidenced through writing and the appending of signatures of all parties’ subject to the contract. Though reaching an agreement is no easy task, an attorney can encourage the owners to reach a compromise and sign the buy-sell agreement. The date of the signing is the point in time when the deal is reached.
Identity of the parties involves
A valid buy-sell agreement must have at least two parties- a buyer and a seller and will be laid bare in the contract. Choosing who to sell your business to is not an easy choice and may require that your business partners consent to your preference. Some businesses might require that you go the legal way to settle this.
Valuation clause
The agreement should contain detailed and accurate information on the business’ worth, and since this cannot always be constant, the provision for the valuation method should be explicit. Be it a fixed formula or a professional appraisal method, it is stated clearly.
Buy-sell funding
The expectation is that the buyer will have the financial ability to meet the payment terms when the event is triggered. Therefore, the buy-sell funding option is specified, which can range from a cash sale, insurance policies, to borrowing.
Tax considerations
Depending on the state you are in, proceeds from the buy-sell of business ownership can have a tax liability. For this reason, it is advisable to engage the services of accounting professionals and consultants who can guide you on how to structure your buy-sale agreement and avoid unnecessary tax liabilities. Some firms will offer these multiple business solutions under one roof. For instance, some Carmel accountancy firms offer business valuation, taxation, and buy-sell agreement services under one roof.
Qualifying events
Anticipate and identify the possible events that can trigger a business buy out, so that the company and your interests are protected upon the occurrence of the said events. These could range from death, retirement, disability, divorce, or breach of contract.
3 Types of Buy-Sell Agreements
1. Cross-purchase agreement
This is a type of buy-sell agreement, where the remaining co-owners agree on buying out the shares of the dead or exiting owner for a specific price. The owners will have taken policies on each other, and therefore this kind of agreement will be found in smaller companies.
2. Redemption agreement
A redemption buy-sell agreement is when the company purchases the shares of the dead or the exiting owner. The company uses cash from the life insurance policy of that owner to buy their shares.
3. Hybrid Agreement
A hybrid buy-sell agreement combines both the redemption and the cross-purchase agreements. Here, individual partners purchase some of the shares, and the business buys the remainder.
Business owners should enter into a buy-sell agreement while their interests are aligned. This is because the occurrence of an event trigger will see their interests diverge, and reaching a pricing agreement then might be a difficult or even impossible task.
What’s Next after Settling on a Buy-Sell type?
After a buy-sell agreement is determined, a business valuation mechanism that will be included therein is determined. There are three valuation mechanisms to choose from.
a) Business valuation agreement
The agreement outlines the process through which the pricing of future transactions will be done and arrived at after negotiations. Business appraisers are then used to determine the price that future purchases will occur.
Pros- All partners get to agree on what the process will entail.
– An independent expert determines value.
– There is a defined structure for pricing future transactions.
Cons – This can be a costly exercise
– The final value is not specified as price determination does not happen now.
– Uncertainty on the owner’s part on what will happen when the trigger event happens.
b) Formula agreement
This mechanism uses a specific formula based on the company’s operations to establish value, such as earnings.
Pros- The formula makes known the specific calculations that determine the buy-sell price.
Cons- Formulas do not provide realistic and reasonable valuations over time.
– Interest value may be unrealistic, depending on the time the event is triggered.
c) Fixed price agreement
This valuation mechanism stipulates that the setting of a future purchase price is on a specific dollar amount, stated as a value for the company’s equity.
Pros- All partners get to agree on what the future buy-sell price will be
Cons- Constant business evolution makes the fixed price outdated.
– Owners can set unrealistic prices when they do not know the business value.
– The nature of the trigger event may result in different values.
How to Fund a Buy-Sell Agreement?
- Purchase a life insurance policy- You can fund a buy-sell agreement using a life or disability policy. The policy ensures that the agreement is funded with premium payments, as a measure to ensure that when a time comes that the funds will be needed, they will be available.
- Set funds aside- The business owners may opt to set aside some funds, to the tune of an amount that they feel will be sufficient to cover the buyout costs. These funds are kept in a cash account and away from the company’s life. However, this can present a temptation in those times that the business goes through tough fiscal times.
- Borrow the amounts needed- A company can opt to borrow a loan from the bank to buy out the exiting partner. Unfortunately, this can be stressful for the business, as the loss of a partner can potentially affect the company’s ability to secure a business loan.
Contact Savage Accountancy today for more information on how the right Carmel accountant can benefit your small business.