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Why every small business needs a well-drafted buy-sell agreement

On Behalf of | Sep 8, 2022 | Business Law, Contract Law

The excitement that accompanies the founding of a new business can often obscure some necessary planning decisions. One of the most important questions is planning for the orderly transfer of the ownership and control of the business in the event that the founder is no longer able (or perhaps willing) to continue as the principal manager of the business’ operations.

The most common causes of business transfer are the death or disability of one of the founders, a divorce involving a significant number of shares in the corporation, a change in the fortunes of the business, or an intractable dispute between or among the owners of the business. The solution for all of these problems is a well-drafted buy-sell agreement.

What is a buy-sell agreement?

A buy-sell agreement is a contact between two or more owners of interests in the same business that permits one of the owners to compel the other owner to sell their interest upon the happening of one or more specified events. The buy-sell agreement also specifies the price and manner of payment for the shares to be transferred.

Elements of a well-drafted buy-sell agreement.

  1. Identify the parties. The first task of the person drafting the buy-sell is to identify the individuals who should be made parties to the agreement. The identity of some of those individuals may not be obvious. For example, if the buy-sell is intended to become operative in the event of the divorce of one of the principals, the spouse of that principal should be required to sign the agreement. If the entity has multiple shareholders, each of them must sign the agreement. If the agreement uses a stock redemption to transfer shares, the entity must be a party to the agreement.
  2. Restrictions on transfer of ownership interest. The buy-sell agreement must restrict the right of every party to the agreement to transfer or dispose of an interest in the business without the approval of the other owners.
  3. Identify the triggering events. The agreement must identify the events that will trigger the buy-out provisions. The most common triggering events are the death or disability of one of the principals. If disability is to be a triggering event, great care must be taken in defining the nature of the disability. Other triggering events may include the resignation of a principal or the discharge of a principal by the unanimous vote of the board of directors.
  4. Establish a mechanism for determining the price for the selling shareholder’s interest. Because the value of a business may change dramatically over time, the exact purchase price should not be specified in the agreement. Instead, the agreement should describe a flexible arrangement for reaching a current and fair price for the selling shareholder’s interests. A frequent mechanism is the use of independent appraisers that the remaining shareholders or a neutral party choose, such as the company’s attorney.
  5. Provide for a method of funding the buy-out. Very few businesses will have the cash on hand that is necessary to pay the departing shareholder for their shares (or other interest). In some cases, the corporation can borrow the funds, and in many cases, life insurance policies on the lives of the corporation’s principals are used to provide the necessary cash.

Solid advice from a knowledgeable attorney

Any business owner who sees a need for a buy-sell agreement may wish to consult an experienced business or estate planning attorney for assistance in designing and drafting an effective agreement.