Basic Business Succession Planning: The Buy-Sell Agreement

After years of toil and sweat, your small business is a thriving part of the local economy. But what will happen when you retire? What if you run into financial trouble, or become disabled, or pass away at a young age? Who will take over the business? How will the business take care of your family?

These are important questions, and the only way to provide answers is to create a succession plan for your business. A comprehensive succession plan will address both the management and ownership of the business. One common feature of a succession plan is a Buy-Sell Agreement.

A Buy-Sell Agreement (a.k.a. Shareholder Agreement) is a contract between business owners, or between a business and its owners, that governs the sale of business interests in certain circumstances.

The most common Buy-Sell Agreement is the Cross Purchase Agreement. A Cross Purchase Agreement is a contract between two owners of the same business. Typically, when one of the owners dies, the contract provides that the other owner must purchase the deceased owner’s share of the business. This ensures continuous ownership of the business, which allows operations to continue without much of a transition. It also ensures that the deceased owner’s family receives the cash proceeds of the sale, instead of an interest in the business, which is great if the surviving family members were not involved in the business operations.

The alternative to a Cross Purchase Agreement is a Redemption Agreement. A Redemption Agreement is a contract between a business and its owners. The contract most often provides that the business will redeem the interest of a deceased business owner. Just like with a Cross Purchase Agreement, the business owner’s family receives the cash proceeds of the sale. However, instead of the other owners purchasing the interest directly, the company purchases it. This results in a proportional increase in the percentage ownership of the remaining owners. Because it is difficult to setup a Cross Purchase Agreement with more than two parties, a Redemption Agreement may be preferable for businesses with three or more owners.

To make matters more interesting, Buy-Sell Agreements can address more scenarios than just the death of a business owner. A Buy-Sell Agreement can trigger the sale of a business interest upon a variety of voluntary and involuntary circumstances. For example, a career change, retirement, disability, or bankruptcy could all provide for the sale of an owner’s stake in the business.

Furthermore, Shareholder Agreements do not have to force a sale, but could instead provide the business or other owners with an option to purchase the shares at stake. Often times the agreement will grant an option to purchase the shares of an owner who retires from the company, but require a mandatory purchase upon the death of the same owner.

But what if the owners or the business don’t have the liquidity to purchase the interest of another owner? Well, there are a few methods for funding a Buy-Sell Agreement.

Often times, parties to a Cross-Purchase Agreement will purchase life insurance policies on the life of the other owner. This guarantees that they will have the cash in hand to purchase the shares upon the other’s death. Similarly, a business could purchase life insurance on its owners in order to fund a Redemption Agreement. Sometimes, the life insurance will be purchased by an Irrevocable Life Insurance Trust (ILIT), which could remove the value of the business from the remaining owner’s taxable estate.

Other times, a Buy-Sell Agreement will provide that the purchasing party may pay for the shares with an installment note, which provides an income stream to the family of the deceased owner, and allows the remaining owner(s) to generate the liquidity over time. Sometimes the agreement will utilize both insurance and an installment note. The possibilities are vast.

Buy-Sell Agreements can be very simple, or they can be extremely sophisticated. This type of business succession planning is at the crossroads of corporate law and estate planning. Be sure to discuss your options with an attorney that is well versed in both areas.

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