Why You Need a Buy-Sell Agreement

If you co-own a business with other family members, it's generally a good idea to have a well-drafted buy-sell agreement to protect everyone's interests. Here are some basics about this important document, including the valuation methods used.

There are two basic varieties of buy-sell agreements. The first type is a contract between the parties to have remaining co-owners buy out the interest of a withdrawing co-owner. This arrangement is called a cross-purchase agreement.

Alternatively, the agreement can be between the business entity and all the co-owners to have the entity buy back a withdrawing co-owner's interest. This is called a redemption agreement or liquidation agreement.

In either case, the buy-sell agreement has two main purposes:

1. ‍It restricts each shareholder, partner or member of the corporation, partnership or limited liability company from unilaterally transferring an ownership interest to anyone outside the existing group.
2. It ensures there will be a willing buyer for each co-owner's interest when he or she retires, dies, becomes disabled or another triggering event occurs.

The triggering events are specified in your buy-sell document. Events that should always be included are death, disability and attainment of a stated retirement age. Other triggering events could be, for example, bankruptcy, the loss of one's license to practice a profession, the divorce of a co-owner or the desire to cash out by withdrawing from the business.

Under the agreement, when a specified triggering event occurs, that person's ownership interest must be sold to — or at least offered for sale to — the remaining co-owners or the entity. Next, the buy-sell agreement should stipulate a method for valuing the business ownership interests, along with terms regarding how amounts will be paid out to withdrawing co-owners or their heirs.

Common valuation methods include a fixed per-share price, using an appraised fair market value figure, or following a formula that sets the selling price as a multiple of earnings or cash flow. You want to make sure any price-setting method is respected by the IRS for estate tax valuation purposes.

Most buy-sell agreements grant the remaining co-owners or the business entity a right of first refusal to buy the withdrawing co-owner's interest. If that right is not exercised, withdrawing co-owners (or heirs) are typically free to sell the ownership interests to an outside party without any need for permission from the remaining co-owners.

The end result is a guaranteed market for each withdrawing co-owner's interest coupled with the ability of the remaining co-owners to retain control of who can join the business. As you can see, this is a beneficial financial arrangement for all parties — whether you're the first original co-owner to withdraw or the last owner standing.