The Key Components of an Effective Buy-Sell Agreement

Blueprint for a Smooth Exit

Recently, I wrote about the importance of operating agreements among the members of limited liability companies. One very important function of an operating agreement is to establish a blueprint when a member exits a limited liability company, whether voluntarily, such as by retirement, or involuntarily, by reason of death or disability, or a forced sale due to divorce of financial exigency.

For corporations, whether C-corp or S-Corp, a buy-sell agreement can serve a similar function, and enable the seamless exit of a shareholder without disrupting the operation of a business.

Three Issues of a Shareholder Exit

The exit of a shareholder will necessarily raise three issues. Business owners will:

1. Want to control the selection of a replacement for a departing owner;
2. Ensure that the liquidity requirements of their business are not negatively affected by the need to fund a buyout; and
3. Ensure that their families are financially secure in the event of their death or disability.

The 6 Key Components of an Effective Buy-Sell Agreement

1. Careful definition of the events that will trigger the purchase of a departing owner’s interest in a business;
2. Identifying eligible purchasers of a departing owner’s interest, whether the company, the remaining owners, specific third parties, or some combination of the three;
3. Establishing a valuation of a deceased owner’s interest for estate tax purposes
4. Defining the mechanism to determine the purchase price upon the occurrence of a triggering event
5. Establishing a mechanism to fund a buyout, generally with insurance, such that the liquidity of the business or the remaining owners will not be negatively affected.
6. Typical triggering events are
   1. Death
   2. Disability
   3. Retirement
   4. Divorce or bankruptcy
   5. The desire to monetize an interest by selling to a third party.

Purchasing Shares of a Departing Owner

Business owners actively involved in the management of a business will want to control the selection of a successor to a departing owner. The right to match a third party offer provides an effective degree of control. Owners who exercise a right to match may:

1. Purchase the shares of a departing owner in accordance with the valuation method, and on the payment terms internal to the buy-sell agreement; or
2. Cause the entity to purchase the shares in accordance with the valuation method and on the payment terms internal to the buy-sell agreement.

Establish a Dependable Funding Source

Where the triggering event is death or disability, purchase of the departing owner’s interest is mandatory, and insurance policies provide the optimal means of securing a reliable source of funding. Innovative new insurance products have made funding buy-outs less burdensome. An astute financial advisor can construct an insurance portfolio allocated to whole life, universal life, variable life, variable universal life or term insurance, or a combination of these kinds of insurance to provide a dependable and affordable funding source.

Plan Ahead to Ensure a Smooth Exit

No one lives forever, and few of us want to work forever. Those of us with business partners should plan ahead to ensure that our inevitable exit from the day-to-day is a smooth one.