You and your business partners put together an idea to make money, and you worked to make that idea come true.
To achieve success, you had to pay attention to the details.
However, remarkably few small business owners account for the future of the business’s ownership and continuity. A good buy-sell agreement does just that.
In this guide, we discuss the purpose of a buy-sell agreement and why you should have one.
What Is A Buy-Sell Agreement?
The buy-sell agreement definition is an agreement that formalizes the understanding between the owners of a business if one of the owners separates.
Without a business buy-sell agreement, a separation can be disruptive and possibly paralyzing. Separation events fall into two general categories: unforeseen and foreseen.
Unforeseen events include when a business partner:
- Becomes disabled;
- Gets divorced; or
- Declares bankruptcy.
Foreseen events include when a business partner:
- Alters their vision for the company;
- Loses interest in the business;
- Needs a cash infusion; and
- Acts in bad faith and willfully harms the business.
In each of these events, you can end up with a business partner you don’t want. To further clarify, a business buy-sell agreement is appropriate for any owner who desires to:
- Control who their business partners are;
- Protect the continuity of their business;
- Preserve the value of their company; and
- Insulate the day-to-today operations of their business.
In addition to the above, investing in a buy-sell agreement also bolsters the business’s value to potential investors and buyers.
Key Terms to a Buy-Sell Agreement
Simply having a buy-sell agreement in place does not mean that you have cleared the horizon of all ownership issues. Let’s explore several basic terms that a buy-sell agreement must contain to be effective.
When any triggering event occurs—such as those listed above—all appropriate parties are given notice.
At its most basic level, notice requires a minimum form (e.g., being written and sent by FedEx) and a minimum amount of information (e.g., the separation event and names of relevant third parties).
Notice then starts a period of time wherein the business partners must elect to take certain actions. For instance, suppose a business member’s divorce is finalized.
That member must notify the other owners that they have a certain amount of time to purchase the divorcing member’s ownership interest to avoid the ex-spouse becoming a business owner.
There are various ways to value a business, and a disagreement about valuation will almost certainly arise if not formalized in a buy-out agreement.
Without such a provision, each party will naturally choose the valuation method that is most advantageous to them. Disagreements about valuation can be extreme and devolve into litigation and possible judicial dissolution of the business.
Accordingly, choosing a valuation method is an indispensable provision to include in a buy-out agreement. Let’s look at some sample valuation methods:
- Times Revenue—a revenue stream generated over a certain period of time is applied to a multiplier determined by industry factors and the economic environment.
- Discounted Cash Flow—using projections of future cash flow determines the current market value of the business. The main difference between this method and the times revenue method is that it takes inflation into consideration.
- Book Value—subtract the total liabilities of a business from its total assets to arrive at book value.
- Liquidation value—the net cash that a business would receive if its assets were liquidated and liabilities were paid off today.
We encourage you to consult a skilled and experienced business lawyer to understand these and other valuation methods in more depth.
An owner’s separation from a business may require gathering a significant amount of cash to purchase the ownership interest.
That said, more often than not, ownership interest purchases are structured as a blend of cash and financing.
For instance, in a $100,000 purchase of a separating owner’s interest, the buy-sell agreement may require a 25% down payment in cash and then the balance of 75% paid by a promissory note.
Lookback protection prevents bad faith dealing. It requires the business, or the remaining owners, to include a separated owner in any sale of the business that occurs within a certain time from the purchase of the separated owner’s interest.
The lookback period protects unsuspecting owners from owners that engage in self-dealing. The self-dealing owner typically sets up a deal to sell the business without letting the other owners know.
Then, they buy out the other owners at a low rate and turn around and sell at a higher price to maximize their own profits.
A lookback provision helps prevent this practice by requiring the sale benefits to apply to any owner for a certain period of time after they have sold their ownership interest.
Once an owner is separated from the business, they may potentially still be able to harm the business unless some precautions are taken.
Placing restrictions on your former business partner can be an appropriate way to protect your company. Therefore, a buy-sell agreement should contain some of the following exit provisions:
- Confidentiality agreement—requires the separated owner to keep certain information regarding the business confidential;
- Non-compete agreement—prevents the separated owner from competing with the business; and
- Non-disparagement agreement—prevents the separated owner from speaking poorly of the business.
These provisions can preserve the continuity and value of your business after the separation of an owner.
How a Business Law Attorney Can Help
Massingill are experts in counseling owners of closely-held businesses. Within that counsel, we regularly craft custom buy-sell agreements for our clients.
We consider these agreements part of the full package of business documents needed for business owners to best protect themselves and maximize their interests.
Contact us today to see what we can do for you and your business partners.