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What are Buy-Sell Agreements and Do I Really Need One?

what are buy sell agreements

When you go into business, it is quite possible you have someone depending on you. Whether it is an employee or a partner or whoever, these people rely on your company to supply them with the livelihood. With that have you ever considered what would happen to those people if you died or even ended up permanently disabled? That’s where predetermined agreements come into play. But what are buy-sell agreements?

What are a Buy-sell Agreements?

A buy-sell agreement is a legally binding document that answers the who, what, when, where, why, and hows of selling your business. These legal contracts have various provisions addressing when and how a business might be sold. For example, if there are restrictions or limitations on selling the company, this document would identify those for the potential buyer. It also lays out how the business will be valued.What are Buy-Sell Agreements

The documents direct how the sale of the business will be paid, as well as pinpointing who receives the funds. It basically explains all the details of transferring ownership of the entire business to the potential buyer. These legal papers take into account all the varying circumstances a business owner may face, providing a means that the business asset is equally distributed based on a pre-agreed formula.

The majority of the time, buy-sell agreements are used for partnership or for transferring the business to key persons. 

Pricing and Funding a Buy-sell 

The most significant issue concerning companies isn’t necessarily whether they should enter into a buy-sell agreement, but rather how to calculate the pricing of the buy-sell and how to fund it. That is typically the biggest sticking point. There are many ways to calculate the value. You can utilize anything from a percentage of revenue to hiring an appraiser. It just depends on what your particulars are. Hiring a good lawyer and accountant and CERTIFIED FINANCIAL PLANNER™ can help you come to that necessary figure.

A cautionary tale when to comes to these is not making sure you obtain at least fair market value. Recently, I met an individual whose buy-sell was based on book value, which is determined via the balance sheet. The problem with that is when this particular buy-sell agreement was when executed, the person who demanded the buy-sell followed the terms, but the partner had to take a significant loss. This did not include fair market value. So in setting up a buy-sell, do make sure it is at least a fair market value.

Once you know your terms, you need to look into funding it. That can be covered numerous ways. Some choose to borrow money from a bank, while others want to do it self-funded. Self-funding is where the seller provides a  loan to the buyer for a period of years. You will also want to provide funding if disability or death attacks. Funding is contingent upon your specific circumstances.

Buy-sell Structures

When structuring your buy-sell, there a few different options to choose from. Here are three of the most popular:

1. An Entity Purchase Buy-sell

That’s when you go through a divorce or a sickeners or injury, and you decided you just want to sell your portion of the business. Then the entity, or the business, purchases the share of the departing partner.

2. A Cross-purchase Buy-sell

I see these the most. The partner buys out the portion of the business the departing person is selling. So the business is not even involved this sell. The end result is similar in these two if you only have two partners because the one will end up with a 100% of the company.

3. A Wait-and-see Purchase Buy-sell

This is where the agreement is left open-ended. The business or other owners are both eligible to complete the purchase. Typically the business is offered the option of purchase first. However, if that is not utilized, then next in line would be the remaining partners.

The Disadvantages of Buy-sells

Now that you know what buy-sell agreements are and their importance, you also need to realize there is a possible disadvantage. Costs will be involved in setting them up, so take into account that expense.

Next, these legal agreements could limit your freedom when it comes to selling to an outside party. We are actually dealing with a client in that very scenario. They realized if they entered into a buy-sell agreement they would absolutely have to honor the terms of that agreement and did not feel that was the best option for them. So instead, they chose to self-insure. That’s where they bought their own life-insurance policy to provide the funds in case the beneficiaries of this estate wanted to maintain the business they could. In choosing the buy-sell option, they would be legally bound to follow the terms.

The lack of buy-sell agreement could bring your company to financial ruin. However, not having one it could also open the door for more opportunities. Whichever you chose, be sure to talk with your advisor to know which option is right for you. If you have questions or need help setting up a buy-sell agreement, feel free to contact me.

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