Buy-Sell Agreements; Why Every Small Business Owner Needs to Think About Their Ultimate Exit

In a business’s initial stages, business owners rarely think about their ultimate exit. We prepare for “exits” in various other aspects of our lives, whether it is a prenuptial agreement, or the creation of a will, but seldom does a business owner take the same steps to protect their business. A buy-sell agreement is an easy and effective way to plan for your exit from a business. If done properly, the transaction can be funded using life insurance proceeds to purchase the deceased owner’s interest.

What is a Buy-Sell Agreement?

A buy-sell agreement, often drafted as part of a shareholders’ agreement or operating agreement, is an agreement between the owners of a closely held business, which restricts the rights of the owners to transfer their interests in the business. The transfer restriction usually gives the owners the right to purchase the interests of an owner when the owner dies or wishes to make a lifetime transfer of his interest. As a result, the buy-sell agreement prevents the interests of the deceased business owner from passing to others—outside of the business—whom the remaining owners may not want to have interests in the entity. In addition, when structured in tandem with a life insurance policy, the buy-sell agreement can also provide liquidity to the estate of a deceased owner.

Using Life Insurance to Fund a Buy-Sell Agreement

Often, buy-sell agreements are structured in tandem with a life insurance policy, and the proceeds of the policy are then used to fulfill the purchase obligations under the terms of the buy-sell agreement. Structuring the buy-sell agreement this way can help to ease the financial burden on the business and owners upon the passing of a partner.

Types of Buy-Sell Agreements

Most buy-sell agreements are structured either as a redemption agreement, a cross-purchase agreement, or a hybrid of the two. Under a redemption agreement, when an owner dies, the business entity will buy the owner’s interest. When drafting a redemption agreement, it is important that the agreement clearly states how the life insurance proceeds will affect the purchase price as this can have financial and tax implications. Under a cross-purchase agreement, when an owner dies, the remaining owners will buy the deceased owner’s interest. Under a hybrid approach, the owners are afforded a bit more flexibility, in either the entity or the owners, to buy the deceased owner’s interest.

Conclusion

The death of an owner in a closely held business is a difficult time for both the business and the decedent’s family. Proper planning with a buy-sell agreement and insurance can facilitate a smooth transition to the surviving owners while also providing liquidity to a deceased owner’s family during an already difficult time. For assistance in drafting your buy-sell agreement, or to learn more about business succession planning alternatives, please reach out to attorney Nataly Kaiser at nkaiser@lavellelaw.com to schedule a free consultation.