If you’re going into business with a partner or partners, it is recommended to have a buy-sell agreement with them to protect your investment in the business. A buy-sell agreement is essentially a contract among partners concerning under what circumstances a partner may sell his or her interest in the business and who can purchase it.
If you put a significant amount of time, money and work into a business, you don’t want to see that investment threatened by a sell-out to an outside party who may want to sell off or close down the business. You also don’t want your investment jeopardized by partners who may turn out to be irresponsible or poor decision makers. A buy-sell agreement can help protect against these risks.
There are three basic concepts at the center of any buy-sell agreement: transfer of ownership and right of first refusal, rights to force buyouts and a determination of how much each partner’s share is worth.
More specifically, most buy-sell agreements contain language dealing with:
- Who can buy a departing partner’s interest in the business. Some agreements give the other partners or employees first dibs on buying the interest of the departing partner.
- Under what circumstances the other partners in the business can force another partner to sell his or her ownership stake.
- Under what circumstances other partners can be forced to buy an ownership stake of a departing partner.
- The value of each partner’s portion of ownership of the business.
- Specific payment and other details of a buyout.
Many buy-sell agreements are freestanding contracts among the owners of a business, while some are written into the partnership agreement or incorporation documents of a business.
Why buy-sell agreements are important
When a partner in a business wants to cash out and leave the business, it can create uncertainty and hardships for the other partners, particularly if the departing partner sells his or her share to another party the other partners don’t want to work with or whose interests run counter to theirs.
The best defense against having an unwanted outsider gain a portion of your business is to have a right of first refusal written into the buy-sell agreement. A right of first refusal allows the other partners the right to buy the departing partner’s stake before he or she is allowed to sell it to another party.
Many buy-sell agreements require each remaining partner to buy an equal portion of the departing partner’s share of the business, in order to keep one or more partners from seizing majority control of the business by snatching up a departing partner’s ownership stake alone.
Forcing a buyout
In some circumstances, an owner or owners of a business may want to force a buyout of the business. There are several situations where this may occur, such as the death of a partner, negligence or criminal actions of an owner, bankruptcy or divorce of an owner, etc.
By adopting a forced buyout provision, partners can protect their interests from business-disrupting scenarios such as death, divorce, arrest, bankruptcy, etc.
For example, three partners own a plant nursery. One of the partners dies, and the other partners would rather not have to work with his heirs – two college age children. Under a forced buyout agreement, the partner’s death would give the partners the option of buying the other partner’s share from his heirs instead of giving them an ownership stake in the business.
Forced buy-out agreements have a flipside, that is they can be used by a departing partner to force the other partners to buy his or her shares in the business. This can be problematic, however, if the other partners do not have the funds to buy the other owner’s share.
Another key point of a buy-sell agreement is setting prices for each partner’s ownership stake in the business.
Departing and remaining partners may have different ideas about the value of one partner’s stake, and this can lead to acrimony and litigation. A buy-sell agreement can head this off by establishing a formula for determining the overall value of the business and the value of each partner’s share. The agreement can also set terms of ownership transfers, such as how they can be funded, how payment is made, etc.
There are a number of ways to value your business and you and your partner’s shares in the business. For example, you may set a pre-set price or you may choose to evaluate the value of the business.
One potential downside of establishing a set price for the value of a business is that the value of the business may increase between the time the business is established and the time you choose to cash out, if the business is successful.
It may be worthwhile to base the price on the book value of the business, a multiple of the book value or capitalization of earnings.
The book value of the business would be the value of the business’ assets minus its liabilities. Depreciation may make this method disadvantageous to a departing partner, however. Basing the price on a multiple of the book value of the business may be a fairer way to determine a departing partner’s share.
Using a capitalization of earnings approach is essentially using a multiple of the earnings of the business. This method bases the business’ value on its record of profits. This method is most appropriate for established businesses, who have several years of profits to establish a record. The valuation starts with the business’ yearly profit multiplied by a pre-determined number. The multiplier is chosen by owners and may reflect several factors, such as the general economic condition at the time of the sale, business type, condition of the business, or multipliers used by comparable businesses in their buy-sell agreements, etc. Multipliers in capitalization of earnings valuation usually run from 2 to 10.
Some buy-sell agreements have provisions where ownership value is determined by an independent appraiser. This method may be the easiest and least contentious method of valuing the business.
When drafting a buy-sell agreement, you’ll want to check to be sure that the terms of the agreement do not conflict with any other agreements among the partners. Conflicts may lead to disagreement and possible litigation.
Do I need a buy sell agreement?
If you’re trying to determine whether your business needs a buy-sell agreement, ask yourself the following:
- Do I have one or more partners in my business?
- Are there situations that may arise – divorce, death, bankruptcy, disability – that would make it necessary for one or more of the partners to buy out my share or a partner’s share?
- Would the introduction of an outside partner be disruptive to the business?
- Would I and the other partners prefer an opportunity to buy a departing partner’s share ourselves before it is offered to other buyers?
- Would I be uncomfortable if the other owners of the business bought all of another partner’s ownership stake, increasing their control of the business?
- Can I envision a circumstance in which I would need to make a quick departure from the business and need the other owners to purchase my ownership stake?
If you answered yes to several of the questions above, entering into a buy-sell agreement with your partners may be advisable, as it can protect your investment in your business and prevent disruptive or acrimonious transfers of ownership and power in the business.