Any business with more than one owner, regardless of where it is in its lifespan, should have a plan in place to address what will happen when an owner exits the company.

Why? An owner may suddenly depart the business due to health reasons or even death. Or an owner’s misconduct may make his or her exit desirable. A business doesn’t have to be long-established for such events to occur.

Protection From Conflicts, Unwanted Owners

Without a plan in place to address scenarios like these, major conflicts among owners (and sometimes an exiting owner’s family) can flare up about how to handle the departure. Worse, the business can end up stuck with unwanted owners, such as an exiting owner’s family members or ex-spouse, or even outsiders. A buy-sell agreement can prevent these negative consequences — and provide other benefits, too.

A buy-sell agreement is a contract between the owners that establishes what happens with an owner’s shares when he or she exits the business. Usually the agreements call for either the business itself or the other owner(s) to have the right — or the obligation — to purchase the exiting owner’s shares. Typically such agreements provide a method for establishing the sale price. Agreements also can specify situations when owners can be forced to sell their shares.

In addition to protecting the business and nonexiting owners, buy-sell agreements can protect exiting owners and their families by providing a ready market at a fair price for shares that might otherwise be difficult to sell. If properly funded, the agreement can also provide them with cash relatively quickly that may be needed to pay expenses or estate taxes.

Funding the Agreement

If the objective is for the business or other owner(s) to purchase the shares, it can be beneficial to include a funding mechanism in the agreement. Often life insurance is used for this purpose.

There are two common types of buy-sell agreements that are funded with life insurance:

1. Redemption agreements. Under these arrangements, the business purchases life insurance on each of the owners. When an owner exits the business, the business uses the proceeds (or cash value) of the policy to buy back the owner’s shares. However, redemption agreements can have undesirable tax consequences.
2. Cross-purchase agreements. Here each owner buys a life insurance policy on each of the other owners. When an owner exits the business, the owners buy back the exiting owner’s shares with the policy proceeds (or cash value). Cross-purchase agreements can work well when there are only a few owners but can get very cumbersome if there are more. For example, even with just 5 owners, 20 policies are necessary.

Professional Advice

This has been only a brief overview of buy-sell agreements. There are many considerations involved in drafting and implementing a buy-sell agreement that will achieve your goals. We can work with you and your attorney to effectively structure an agreement, including funding mechanisms. Please contact us to learn more.