Simply put, a buy-sell agreement is a binding contract between co-owners that controls when an owner can sell his interest, who can buy an owner’s interest and what price will be paid for that interest. A buy-sell agreement can control all transfers of business ownership to the benefit of both the owner wishing to transfer ownership and the other owner (or owners) wanting to acquire ownership. This agreement can assure a selling owner (or his/her estate) of a purchase for fair value and upon terms and conditions that are acceptable to all parties.

So what does a buy-sell agreement accomplish?

  • It controls who can own an interest in the company by preventing an outsider from purchasing an interest.
  • It provides a guaranteed buyer for your ownership interest because realistically there aren’t too many people lined up to buy your minority interest or less than a 100% share of a small business.
  • It determines what triggering events will invoke the buy sell provisions such as death, disability, retirement, divorce, bankruptcy, resignation and firing.
  • It can set a fair price and a workable method for paying for and funding a buyout, which includes payment terms and the source of funding.

I think it’s best if you adopt a separate distinct agreement instead of including the provisions in your Bylaws or Operating Agreement.  This ensures that every owner (and their spouse) knows and understands the importance of the buy-sell provisions and won’t later claim surprise.  The caveat of course, is to make sure the buyout provisions don’t conflict with any existing organizational documents and of course, why I recommend you use a qualified transactional attorney to review all of your documents so s/he can draft a proper buy-sell agreement.

Three Types of Buy-Sell Agreements:

  • The Entity Purchase Buyback – which means that the company has the obligation to purchase a departing owners interest.
  • The Cross Purchase Buyback – which states that only the continuing owners have the option to buy a departing owners interest.
  • A Combination of Entity Purchase Buyback & Cross Purchase Buyback, which allows both the company and the owners to purchase the departing owners interest. This is the most flexible because it doesn’t force one or the other.  It allows the decision to be based on the current financial status of both the owners and the company.

How to Fund a Buyout

A big part of the discussion is knowing where the money will come from or the plan can’t be implemented.  There are several methods available:

Cash. This is the simplest method. However this requires the company and/or the owners to maintain large cash reserves available at all times. Unfortunately, cash is not always available when you need it most and depending on your business, you may need a large amount.

Secure a Loan. With this method there is no immediate outlay of cash, however there could be some problems especially if the death, disability or retirement of a co-owner affects the ability to qualify for a loan or what if the interest rates are too high making a loan unaffordable.

Life Insurance/Disability Insurance.  Both are attractive methods for funding a buyout. This makes sense if the situation is the result of death or disability, and may potentially work for a buyout of a retired owner as well.  However, this method does not work for divorce or bankruptcy.

Use of an LLC to Structure and Fund a Buy-Sell Agreement. In a recent Private Letter Ruling, PLR 200747002, the IRS accepted a strategy that has the advantages of both cross-purchase and redemption agreements without the disadvantages of either. With this structure, the members sign a cross-purchase agreement and form a new LLC (with special provisions), taxed as a partnership, to own the life insurance. The cross-purchase agreement and LLC operating agreement have provisions that reference each other.  The IRS ruled that the life insurance death proceeds would not be includible in the estate of the deceased LLC member. Thus, this structure contains the advantage of the traditional buy-sell structures without the disadvantages.