What Is A Buy Sell Agreement?

By Jeffrey Sternberg, JD

"We don't need a buy sell agreement" is heard on a daily basis by accountants, attorneys and financial advisors from their clients who own small businesses. Business owners never want to plan for the day when they need to go their separate ways due to personality conflicts, different business strategies, or simple retirement. The divorce, death, loss of a business license or disability of an owner can trigger unforeseen consequences to a profitable business. A business with one owner rarely develops a business continuity plan in the event of death or disability.

A buy sell agreement provides the blue print of how to buy out a co-owner, including the price and the terms of payment for the purchase. A buy sell agreement can also restrict the transfer of stock to an unknown and unwanted third party owner.

Any business with two or more owners should have a buy sell agreement. A business owner frequently spends more time with co-owners than with a spouse and family. As some marriages end in divorce, some business relationships end. The breakup of business owners can be costly and messy without proper planning. With a carefully prepared buy sell agreement; a business owner could be required to sell his or her interest in the event of any of the following:

  • Death of an owner. If an owner dies owning 50% of the business, the typical beneficiary of the decedent's interest would be his or her spouse. Most people do not want to own a business with a co-owner's spouse, and in most cases, the spouse can't effectively replace the deceased owner.
  • Divorce. If an owner is in the process of a divorce, it may be possible that the soon to be ex-spouse could end up owning a piece of the business.
  • Long Term Disability. How long can a business afford to pay a non-working owner a salary when a disability prevents him or her from working?

Restricting who can own the business can become important due to the concerns listed above. Also, imagine if a co-owner decided to sell his or her minority interest to a third party; the majority owner might not like the new owner. Without restrictions in place, the stock of a corporation could be sold, gifted, or transferred to a third party without the consent of the other owner(s).

A buy sell agreement can provide a "right of first refusal" to the remaining owners. Before the departing owner can transfer his or her business interest, the remaining owners must first be offered the opportunity to purchase that interest for the same terms. Upon the death or disability of an owner, the family typically would like to get paid for the business interest. However, determining the fair market value of the ownership interest is a difficult and complex task. A buy sell agreement can provide a formula to determine value; some agreements are updated annually to describe the price per share.

For a sole shareholder/single member business owner whose family is not in position to take over their business operations a continuity plan is important. In most states, only a licensed individual can own a medical practice or financial planning practice. Finding a compatible person to purchase the practice upon death or disability would allow a transition of the practice to a handpicked successor. The business continuity agreement or buy sell agreement would provide the security of knowing that someone will be purchasing your practice upon your death or disability.

The key items in the continuity agreement would be the (i) purchase price or purchase price formula to determine the value, (ii) terms of the payment such as the initial down payment, time frame to close and promissory note format to follow and interest rate on the outstanding funds owed, (iii) the allocation of the purchase price (usually all to goodwill if the purchase is because of death since the seller can't compete or consult), (iv) the triggering event such as death or loss of license and (v) provide the buyer with a right of first refusal if agreed to by the parties if the seller decides to sell the practice while alive but before the triggering event such as in the case of retirement.

The failure of a business to plan for the life events of its owners can bring about the end of a successful business, not to mention the cash flow, which supported the owners and their families. Arguments and disagreements can ruin long-standing friendships. Sensible planning, using a carefully prepared buy sell agreement, can avoid such tragedies and provide peace of mind to business owners.