When you set your company with your business partners, all of you agreed on your share of the company. However, at some point, you’ll have to reassign each of your interests. Events like death, bankruptcy, retirement, disability and divorce will require an interest’s reorganization. To ensure a smooth interest succession, you may consider creating a buy-sell agreement.
A buy-sell agreement is a contract between the shareholders of a company. It states how a partner’s interests will be reassigned in the case of a triggering event (like the death or resignation of a partner). It will also specify when, to whom and for how much a partner can sell their interest. Shareholders create these agreements to keep control of the company, as the contracts specify that a partner’s interest must be sold to:
- The company or business entity (redemption agreement)
- The remaining shareholders (cross-purchase agreement)
Buy-sell agreements keep a company’s interests within the partners and ensure that no unwanted outsiders become a company’s owner. That is why this type of agreement is common in family businesses.
When an owner leaves the company for whatever reason, the remaining shareholders need to know how much their interest is worth to buy it. Buy-sell agreements include a valuation clause that determines how to measure the value of a shareholder’s interest. There are many valuation methods, but the most common are:
- Formulaic valuations: a specific formula set in the contract to calculate value.
- Appraiser’s calculation: an accountant makes periodic valuations on the company, so the shareholders already know the interest’s value if a triggering event happens.
Most shareholders prefer the appraiser’s calculation because the company’s value is constantly changing, and a formulaic valuation may lead to inaccuracies because of its simplicity.
The remaining owners will not use their personal savings to buy a shareholder’s interest. To get funds for the purchase, shareholders can either use the income earned from the business or use the deceased partner’s life insurance proceeds.
The importance of an attorney
Buy-sell agreements become effective under stressful circumstances. Conflicts may arise during the process, so the contract must be specific and leave no space for misinterpretations. An experienced business law attorney can draft the agreement to ensure that the terms are clear to all the shareholders. That way, the buy-sell agreement can ensure a smooth transition and protect the business from chaos.