Understanding the buy sell agreement: How They Work & What You Should Know

A buy-sell agreement is a legal contract that outlines the process for the entry or exit of a company shareholder. It documents how an owner’s interest in the company may be swapped, purchased, and sold in the event of certain predefined events. These events can include death or termination of employment with the company due to a disability or other reason. 

Business Example: Maverick Cleaners Co

For instance, let's say Maverick Cleaners Co. has four business owners — Robert, Susan, Michael, and Debby — each with a 25% stake in the business.

If Robert dies and there is no buy-sell agreement, his share would be passed on to his estate. That would allow his heirs to have an ownership interest in Maverick Cleaners Co — which might not go well with the other co-owners. A buy-sell agreement could prevent this by only allowing Susan, Michael, and Debby to buy Robert’s stock in the business upon his death. 

How do buy-sell agreements work?

Buy-sell agreements define how a business will proceed if an owner or partner dies or leaves the company. 

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Typically, buy-sell agreements involve the following steps:

1. Determine the events that trigger a buyout. For example, death or disability of an owner.
2. Determine all the parties that have rights and purchase obligations.
3. Set the purchase price or define the formula or process for valuing the business. 
4. Establish how the buyout will be funded. For example, will the agreement leverage any other life insurance policies?
5. Define what will happen if one or more involved parties do not use their purchase rights.
6. Declare whether the business will be restructured after the buyout. If so, how will it be restructured?

The agreement is essentially a barter between the owners in the event that one of them passes away. This trade will assist the company to run smoothly even after tragic events.

Types of buy-sell agreements

Each company is different. There is no such thing as a one-size-fits-all buy-sell agreement. To assure business continuity in the case of a stakeholder's death, incapacity, or retirement, thoroughly assess your company's particular circumstances. To determine which sort of buy-sell agreement will best suit your requirements, consult with a trusted buy-sell agreement broker at Dundas Life.

The four most common types of buy-sell agreements include:

Cross-Purchase Agreement

A cross-purchase agreement allows company shareholders to buy the shares of a co-owner when a triggering event occurs. As part of the agreement, each business owner purchases a life insurance policy on the other business partner(s). 

• For example, let's imagine Mike and Arnold co-own a bakery business called SmoothDough. To ensure business continuity and a smooth swap of ownership from the departing partner, they enter any cross-purchase agreements. This means that each owner buys life insurance on the life of the other and pays the premiums out of their own pocket. The beneficiary of Mike’s policy will be Arnold and vice-versa. 

Redemption Agreement

In a redemption agreement, the company itself purchases the shares when a triggering event occurs.

A company will usually use life or disability insurance to help fund a repurchase if a shareholder passes away or becomes disabled. The company pays the premiums, and the company is also the beneficiary. Typically, only one policy is purchased per shareholder. 

• Continuing with the above example, instead of Mike and Arnold buying a policy on each other, their company, Smooth Dough, purchases a policy on both of them and pays the premiums. If an owner dies, retires, or becomes disabled, Smooth Dough, as the business entity, will use the proceeds of their life insurance policy to repurchase their stocks for a preset price.

Hybrid Agreement

A hybrid agreement can create certain obligations and rights for both the shareholders and the company. For instance, a hybrid agreement can require cross-purchase agreement obligations under certain circumstances, like the death of a stakeholder, and redemption obligations for specific events, like the retirement of most business partners. 

• For example, under a hybrid agreement, Mike and Arnold take out life insurance policies on each other. If one of them dies, the other will buy the deceased partner’s stocks at a pre-determined price based on fair market value. However, since not all disrupting events are insurable, Mike and Arnold decide to go with the redemption option for other situations. So, when either of them retires, SmoothDough will repurchase their stake in the company at a fixed price. 

Entity Purchase Agreement

In an entity purchase agreement, the business entity itself purchases the shares of a stockholder when they leave the company. The remaining business owners then rearrange their stake in the business so that they are equal partners.

• For example, let's say in the scenario above, SmoothDough was shared between three owners originally: Mike, Arnold, and Pete, all with equal shares in the company. If Pete dies, his share of the business will end up getting split between the other two owners, based on the fair market value of the shares. This way, Mike and Arnold will end up having equal 50/50 shares in SmoothDough, instead of having the company be passed on to Pete's heirs.

Who needs a buy-sell agreement?

Any business with more than one owner benefits from having a buy-sell agreement. However, a limited corporation and a sole proprietor may also benefit from setting up an effective buy-sell agreement. 

The following types of businesses are likely to need a buy-sell agreement: 

• doctor’s offices
• dental offices
• law firms
• auto mechanics
• physical therapists
• family-owned businesses
• local retailers

What should be included in a buy-sell agreement?

A buyout agreement should clearly outline three things: the triggering events, the process that will be followed for valuing the business at fair market value, and how the sale of ownership will be funded.

Triggering Events

Events that usually trigger a buy-sell agreement include, but are not limited to, the following: 

• the death of a shareholder
• a critical illness 
• a long-term disability
• termination or resignation of the shareholder as an employee
• retirement
• divorce
• bankruptcy declaration

A buy-sell agreement must clearly define what constitutes a trigger event. While certain trigger events, such as death, may not require explanation, others must involve precise and specific descriptions. For example, if disability is mentioned in the contract, it must specify how total disability will be determined. Similarly, the agreement should clearly state which medical conditions will be designated critical illnesses.

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Business Valuation

A buy-sell agreement should define how the business will be valued. Some small business owners choose a pre-determined amount (e.g., $2 or $5 million), while others prefer to use a specific formula (e.g., six times pre-tax earnings) or hire a business valuation expert. If you and your business partners agree to a pre-determined amount, do not forget to review this figure annually since a company’s value can change over time. 

Funding strategy

A buy-sell agreement must outline how any sale of ownership will be funded. The company or the business owners could use the insurance proceeds to buy the business interest. For example, the company or owners may use the payout from:

• Life insurance
• Critical illness insurance
• Disability insurance

In any of these cases, either the co-owners or the business itself would be listed as the insurance beneficiary. When one owner passes away, the benefit then provides funds with which the co-owners or the corporation can buy back the shares of the late owner.

Conclusion

When a partner passes away or leaves the company, buy sell agreements enable a straightforward transfer of ownership. Typically, life insurance is used as a funding mechanism in these arrangements. Speak with a Dundas Life specialist if you wish to set up such an agreement and fund it with a life insurance policy. We can assist you in getting the appropriate level of insurance coverage to protect your company from serious financial and legal problems.

Frequently Asked Questions (FAQs)

Are buy-sell agreements legally binding?

Generally, buy-sell agreements are legally binding. To ensure that agreements are drafted properly to include all of the necessary components, be sure to speak with a legal professional.

Who is the beneficiary of a buy-sell agreement?

The company itself or the surviving business partners are the beneficiaries of the life insurance policy used for funding a buy-sell agreement. Generally, when a corporation has multiple business partners, it is better to name the business as the owner and the beneficiary of the life insurance policy.  When the insured passes away, the beneficiary (either the corporation or the remaining partners) uses the payout to buy the deceased partner’s shares.