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Important Considerations for Buy-Sell Agreements
If a business has more than one owner, it’s crucial that you have a buy-sell agreement in place to detail what will happen in the event one partner wants to buyout the other, or is required to buyout the other for one reason or another.
These agreements are especially important for navigating unpredictable life events – such as death, divorce or disability. Many times, a buy-sell agreement is the single piece of contractual legislation that can prevent financial distress or bankruptcy. The buy-sell agreement can be in the form of a standalone agreement or be part of a broader agreement (such as a shareholders' agreement or LLC operating agreement).
When a buy-sell agreement is executed properly, it will cover terms as to when and how the transfer of ownership will occur, what the purchase price will be, the buyout terms and include the needs and desires of all parties involved to ensure the transaction is done in a fair and smooth manner.
When drafting your business’s buy-sell agreement, it’s important that you include specific considerations to avoid common risks and to prevent any future disputes.
Important considerations for drafting and maintaining a strong buy-sell agreement:
1. Tailor your buy-sell agreement to your specific business needs: Like most legal documents, there rarely is a one-size-fits all format. Every business has different needs and objectives, which is why it’s important to consult a legal counsel to carefully tailor a buy-sell agreement to your business and its partners. Work with your lawyer and other business associates like accountants, wealth managers and/or advisors to draft an agreement that covers all angles and is accurate and precise.
2. Identify the right buyout triggers: The most common buyout triggers are retirement, death, divorce, disability, bankruptcy, failing to meet contractual requirements and termination of employment. In your buy-sell agreement make sure to include language that covers these proceedings, and other possible trigger events, in addition to verbiage that outlines the consequences of these situations.
3. Set realistic payment terms: If a trigger event occurs, it’s important to plan how payment will be fulfilled. Depending on the size of your business, and the ownership interests, your buy-sell agreement should take into consideration budget restraints. Setting up a payment system will help create a buyout outcome that does not put either party in financial distress. If it's possible, purchase life insurance on all partners so that if a partner passes away, the insurance proceeds can be dedicated to purchasing that partner's interest.
4. Use clear and specific language concerning the valuation of shares: Your buy-sell agreement should cover the valuation of shares in a forward-looking manner, while being flexible enough to account for future business benefits. Oftentimes, a buy-sell agreement will call for one or more third parties to assess a business’s value. Other times, the partners may agree on a formula that gets updated on an annual basis (make sure to include language that requires the partners to assess the formula or valuation method each year). Always discuss the best way to approach the valuation of shares with your legal and tax advisor.
5. Review your buy-sell agreement regularly: A proper buy-sell agreement should be reviewed and updated on a regular basis. By updating the agreement yearly, this will help business owners examine any changes in their personal and professional lives. This practice will also prevent future disputes over buyouts because the buy-sell agreement will be updated to reflect all business partners and shareholders’ needs.
Most business owners would prefer not to think about what would happen in the event the other partner passes away, becomes disabled, gets a divorce or leaves the company's employment. These conversations, though difficult, are necessary to safeguard your own -- and the company's -- best interests and to resolve conflict when dealing with unexpected life events.
While it’s impossible to plan for every situation or scenario, constructing a strong and specific buy-sell agreement – and updating it regularly -- will help prevent future disagreements and foster a conflict-free transaction.
DISCLAIMER: The information contained in this article is intended for informational purposes in order to give the reader a general understanding of this important topic. This article is not intended to be legal or tax advice, so if you need additional information, please contact us.
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