What are Buy-Sell Agreements?
A Buy-Sell Agreement is a contract that stipulates how a partner’s or member’s share of a business may be reassigned if that partner dies or otherwise leaves the business. Most often, the Buy-Sell Agreement stipulates that the available share(s) be sold to the remaining partners or to the partnership (This includes Limited Liability Companies, Closely Held Corporations, etc.). Buy-Sell Agreements often use life insurance policies to fund the buyout in the event of a partner’s or member’s death.
Why are Buy-Sell Agreements useful?
- Establish the value of a partner’s or member’s share for estate tax purposes.
- Estate planning purposes for partner’s or members.
- To accommodate remaining partners or members who do not want to continue the business with the family or heir of the deceased partner or member.
- Protect the ongoing business from falling into the hands of third parties.
How do Buy-Sell Agreements work?
Buy-Sell Agreements are used by businesses in an attempt to smooth transitions in ownership when a partner dies, retires, becomes incapacitated, or decides to exit the business.
The Buy-Sell Agreement requires that the business share be sold to the company or the remaining partners or members of the business according to a predetermined formula. In the case of the death of a partner, the estate of the deceased partner or member is the one participating in the sell. To fund the purchase of the deceased partner’s or member’s interest by the surviving partners or members, life insurance policies are often used. That is, the partners or members take out life insurance policies on one another and pay the premiums as a business expense.
When a partner or member dies, the life insurance benefit is paid out to the remaining partners or members. They in turn use the funds to purchase the deceased partner’s or member’s shares from his/her estate. This serves two important purposes. First, the continuity of the business. And secondly and sometimes most importantly, provides the necessary funds to purchase the deceased partner’s or member’s shares. Furthermore, there is no need to battle with the deceased person’s estate in probate court.
Who exactly is purchasing the deceased partner’s or member’s interest in the business?
There are two options available for the purchase of the deceased person’s interest.
- A Cross-Purchase Agreement where the remaining partners or members purchase the interest.
- An Entity-Purchase Agreement where the business entity itself buys the interest.
It is also possible to use a mixture of the two or elect a contingency to control. For example, depending on what is best for the business at the time either option could be used depending on cash flow, investments, or the remaining partners/members. A creative business owner can even draft a Buy-Sell Agreement to provide employees the option to purchase the interest. This is an option for a sole proprietorship. The possibilities are really only limited by the imagination of the drafters of the Buy-Sell Agreement.
So how do you use a life insurance policy to fund a Buy-Sell Agreement?
Whole or term life insurance can be used to fund a Buy-Sell Agreement. The life insurance industry also offers “Business Value Life Insurance” with a death benefit determined by the value of the business rather than the terms of the policy. The death benefit can grow as the value of the business grows. Premiums may also be higher as the death benefit increases. The insurance industry is often at the vanguard of this, and new policies and ideas are always coming up, but the basic principle remains the same.
When should you draft a Buy-Sell Agreement?
Ideally, this should be done at the business’s inception when you draft the Operating Agreement; however, there is no time limit on when you can do this. A business that has existed for years can adopt one as a matter of course so long as the partners or members are in agreement.
A Buy-Sell Agreement also acts to provide stability for a business. There may be moments when a partner or member wants out, and the Agreement can provide a mechanism for that as well and contain a right of first refusal. This is when the departing partner or member is prohibited from selling or transferring his/ her interest without giving the business the opportunity to purchase it first.
What are some considerations that go into the drafting of a Buy-Sell Agreement?
The following are examples of considerations partners or members might want to put in a Buy-Sell Agreement:
- A list of triggering buyout events, including death, permanent disability, bankruptcy, retirement, etc.
- A list of partners or members involved and their current equity stakes (think capital accounts).
- A recent valuation of the company’s overall equity or value.
- A funding instrument, such as life insurance policies.
- Tax and estate planning considerations for the individual partners and surviving beneficiaries.
Wait, are you telling me that Buy-Sell Agreements can also be a part of Estate Planning?
Yes, a well drafted Buy-Sell Agreement can often be an effective mechanism for estate planning. Imagine a scenario where there is an ongoing business, and a partner or member unexpectedly dies. His/her estate is going to receive their share of the business. The grieving widow and heirs will want the value of that deceased partner’s or member’s share, but what if the business does not have the cash flow to purchase the interest from the estate?
The answer is a Buy-Sell Agreement where a life insurance policy has been purchased on the life of the now deceased partner or member. This even works when various partners or members own different percentages of the company.
The deceased partner has the peace of mind when he/she is heaven that his/her descendants receive his/her share of the business, and the remaining partners or members do not have to worry about lawsuits.
Final Thoughts on Buy-Sell Agreements
A Buy-Sell Agreement assures a smooth transition of ownership and business continuity in the event of the departure of a partner or members. The agreement is a legally binding contract that establishes how the departing person’s interest will be obtained by the remaining partners or members. Without such an agreement, there can be legal battles and contestation. For example, if a partner dies without an agreement, their shares will likely pass automatically to their spouse. The remaining partners or members certainly did not fall in love with and marry this person, and they may have no interest in working with them. Alternatively, the surviving spouse may want to transfer the interest to a well intentioned though horribly inept child. The movie industry is rife with films of this nature (e.g., Horrible Bosses, think Colin Ferrell’s character).
Business continuity is important, especially when there are multiple partners members running a business. A Buy-Sell Agreement is a legal remedy for establishing a clear plan of how to distribute the shares of a departed or deceased partner or member to the remaining ones.
If you would like some help preparing or reviewing a buy-sell agreement, please call us at (251) 215-9275 or write us on the contact page to schedule an appointment to discuss how we can help.