The Importance of Buy-Sell Agreements for Business Owners

For business owners, navigating market fluctuations and managing day-to-day operations can be challenging. Entrepreneurs must constantly anticipate and mitigate risks to plan for the longevity of their enterprises. One such risk that is often overlooked but can have profound implications is the absence of a buy-sell agreement.

In this article, we will explore the importance of buy-sell agreements for business owners, examining their key elements, the various types available, and the implications of not having one in place. Additionally, we will discuss the role of buy-sell agreement insurance and why consulting with experts like Avidian Wealth Solutions is essential in safeguarding your business interests.

What is a buy-sell agreement for businesses?

At its core, a buy-sell agreement is a legally binding contract among multiple owners of a single business. It outlines what happens to any given owner’s stake in the company should certain events occur. Think of it as a prenuptial agreement for your business — it sets the ground rules for how ownership transitions will be handled, planning for a smooth transfer of power in times of uncertainty.

A buy-sell agreement for business owners differs from other transfer mechanisms, like gifting business ownership, in the sense that it is an “in case of emergency” protocol; it’s a contingency plan in the event of certain circumstances described in the agreement. These are referred to as “triggering events” and are discussed below..

Watch the video below to hear from Avidian senior wealth advisor and partner, Michael Smith, as he talks about the importance of buy-sell agreements in more detail with Avidian’s director of financial planning, Robert Palmer.

<embed video>

What are the key elements of a buy-sell agreement?

The key elements of a buy-sell agreement lay the foundation for the orderly transfer of ownership in a business. These elements include clearly defining trigger events, which valuation method will be used to determine the price of the business interest being transferred (ensuring a fair and transparent transaction), and the funding mechanism for the buyout,  whether through cash reserves, installment payments, or insurance proceeds.

By addressing these essential components upfront, buy-sell agreements provide clarity and certainty in times of transition, helping to preserve the stability and continuity of the business. 

The following is a list of what should be included in a buy-sell agreement (though, in some cases, the list may be either longer or shorter).

Trigger events

Trigger events are the circumstances that activate the buy-sell agreement. These events typically include the death, disability, retirement, or voluntary departure of an owner, as well as divorce or bankruptcy. By identifying these trigger events upfront, you can mitigate potential disputes and ensure clarity in times of transition.

Valuation methods

Valuation methods are integral to buy-sell agreements as they determine the price at which a business interest will be bought or sold in the event of a trigger event. Valuations are conducted by appraisers commissioned by the parties or by the business itself.

 Common valuation methods include: 

1. Asset-based approach, which assesses the value of the company’s tangible and intangible assets.
2. Market-based approach, which compares the business to similar companies in the industry.
3. Income-based approach, which analyzes the company’s earning potential through methods like discounted cash flow analysis or earnings multiples.

Each method has its merits and may be chosen based on factors such as the nature of the business, industry standards, and the preferences of the owners involved.

Buyout funding mechanisms

Buyout funding mechanisms dictate how the buy-sell agreement will be funded when a trigger event occurs. These mechanisms make sure that the necessary funds are available to execute the buyout without causing financial strain on the business or its owners. Common funding mechanisms include: 

• Cash reserves, or set-aside funds with which the business pays for buyouts.
• Installment payments, which allow the purchasing party to pay for the business interest over time in predetermined installments.
• Insurance-funded buyouts, through which the owners secure life or disability insurance policies to provide the necessary funds upon a triggering event.

Choosing the right funding mechanism depends on factors such as whether the business is preparing for a liquidity event, the financial capacity and tax bracket of the owners, and the feasibility of obtaining insurance coverage.

Learn more about Texas’ income tax brackets

What are the four types of buy-sell agreements?

1. Cross-purchase buy-sell agreement: In this arrangement, each business owner agrees to buy the shares of a departing owner. This type of agreement is advantageous for businesses with a small number of owners, as it allows for a more seamless transfer of ownership.
2. Entity buy-sell agreement: In contrast to the cross-purchase agreement, the business entity itself agrees to purchase the departing owner’s shares. This structure is common in larger businesses with multiple owners, as it simplifies the transfer process and avoids potential liquidity issues among individual owners.
3. Wait-and-see buy-sell agreement: This approach combines elements of both cross-purchase and entity agreements. Initially, the remaining owners have the option to purchase the departing owner’s shares individually. If they decline or are unable to do so, the business entity steps in to acquire the shares.
4. Hybrid buy-sell agreement: As the name suggests, this type of agreement incorporates elements of various buy-sell structures to tailor-fit the needs of the business and its owners. It offers flexibility and customization, allowing for a more nuanced approach to ownership transitions.

Should I have buy-sell agreement insurance?

Buy-sell agreement insurance, also known as key person insurance or business continuation insurance, provides the necessary funds to execute the terms of the buy-sell agreement in the event of a triggering event. By securing adequate insurance coverage, you can plan so that the necessary funds are available when needed, preventing financial strain on the business and its owners.

What happens if you don’t have a buy-sell agreement?

Without a buy-sell agreement in place, the future of your business could be thrown into uncertainty. In the event of a triggering event, disputes among owners or their heirs may arise, leading to prolonged legal battles and potential business disruption. Moreover, without a clear succession plan, the value of your business could diminish, jeopardizing your hard-earned legacy.

Considering a buy-sell agreement for your business? Call Avidian.

Buy-sell agreements are a vital tool for business owners looking to protect their interests and plan for the smooth transition of ownership during an unforeseen event. By understanding the key elements of buy-sell agreements and securing the necessary insurance coverage, you can work to safeguard your business and your legacy for years to come.

As a high-net-worth wealth management firm with experience offering business succession planning and estate planning, Avidian Wealth Solutions is here to guide you through the intricacies of buy-sell agreements. Our team can help you assess your unique needs, identify a suitable buy-sell structure for your business, and work to secure the necessary insurance coverage to help protect your interests.

More Helpful Articles by Avidian: 

• How Was Stock Market Performance in January 2024?
• 8 Benefits of Small Business Tax Accounts
• What is Comprehensive Wealth Management?
• Individual Bonds vs. Bond Funds: What is the Difference?
• The Difference Between a Legacy Trust vs. a Dynasty Trust

---

Please read important disclosures here