Choosing the right spouse might be the most important decision anybody can make. Perhaps the next most crucial decision is selecting the right business partner. This analogy is appropriate because business partnerships resemble our most sacred union in many ways. Business partners marry each other’s passions, visions, and shortcomings. The most successful partnerships are both complementary and interdependent.
Partnerships might span years or even decades with little interruption. Responsibilities evolve with business needs – one partner’s strength might be another’s weakness. This symbiotic relationship drives the business forward through good times and bad. Many view their business partner(s) as indispensable. Few plan for their absence.
What if something happens to your business partner? Consider the all-too-common scenario where one business partner dies without a buy-sell agreement in place. The former partner’s business interest passes to heirs with no active role or expertise in the company. This sudden change can create confusion, lead to conflict, and erode business value.
A buy-sell agreement prevents this undesirable scenario. Well-structured buy-sell agreements facilitate and fund the orderly transition between business partners and their family members.
How They Work
A buy-sell agreement is a legally binding document between company shareholders. The agreement addresses what will happen if a partner passes away, becomes disabled, or otherwise exits the business. The document also establishes a clear framework for how the business will be valued in these situations.
Triggering events are the core of any buy-sell agreement. These are predetermined situations that activate the agreement and set its terms in motion. Death, permanent disability, and resignation are common triggering events. The agreement sets forth who will buy the departing partner’s shares and for how much. Triggering events should be plainly defined to avoid ambiguity or dispute.
Triggering events address transfers between partners. Other provisions address instances where an outside party makes a proposal to buy the business. Many buy-sell agreements extend rights-of-first-refusal, allowing other partners to effectively intercept a third-party offer. Come-along rights and drag-along rights are other common provisions.
Perhaps the most essential component is the company’s value. A clear framework should outline how much each partner’s interest is worth. As we explain in a recent article, there are numerous methods to determine a company’s value. The key is that all partners agree to the number or formula. The calculation might even include discounts to reflect the lack of marketability and control for minority shareholders or value reductions resulting from a key partner’s absence.
How They Are Funded
A buy-sell agreement establishes a buyer and a price for each partner’s share. The agreement can also fund these obligations. Insurance is the most common funding tool.
Insurance protects against life’s most extenuating circumstances. This is true in both personal planning and business planning. Married couples purchase insurance to protect their homes, cars, and incomes. Similarly, entrepreneurs buy insurance to protect their business interests and professional commitments.
Life insurance provides funding if a partner dies. The mechanics are fairly simple. Life insurance policies are purchased on each partner. When a partner dies, the business or surviving partner(s) receives a death benefit equal to the deceased partner’s business interest. This tax-free death benefit is used to purchase the deceased partner’s shares from his or her estate. The insurance policies might be owned by the partners (“Cross Purchase”), the company (“Stock Redemption”), or some hybrid of both. Circumstances and preferences dictate the optimal structure.
Disability insurance provides funding if a partner can no longer work due to injury or illness. Stand-alone disability policies or certain life insurance riders release a benefit after a specified waiting period in these circumstances. The proceeds may cover some or all of the buy-out costs for the remaining partner(s).
Insurance funding has natural limitations. Insurance is designed to protect against unforeseen and accidental events, but some triggering events are purely voluntary. Consider when a partner retires or resigns. In these instances, the remaining partner(s) might buy out the exiting partner’s interest using personal savings or bank loans. They may also borrow against the cash value in an existing whole life or universal life insurance policy. Payments might be made immediately or in periodic installments. The exact provisions for lifetime buyouts ultimately depend upon the partners’ goals, resources, and insurability profiles.
Why They Matter
The case for buy-sell agreements is both corporate and personal. Buy-sell agreements ensure business continuity and provide liquidity for each partner’s ownership interest. Any successful business owner should consider their exit plan and build a strategy that supports it. This is especially true when there are multiple partners in the company.
An individual’s business is often his or her most valuable asset. It is also the most difficult to monetize. Corporations like Amazon and Apple are publicly traded, allowing shareholders to immediately sell their interests to a ready buyer. Privately held companies, however, require more thoughtful planning to determine value and identify a buyer. BaldwinClarke’s business advisory experience demonstrates that the most suitable buyer can be someone close to the company. Existing partners are a natural market and a straightforward succession plan.
Buy-sell agreements also protect longstanding relationships between partners and their families. Business and personal lines often blur as owners build trust, share experiences, and participate in one another’s personal lives. These remarkable dynamics can quickly dissolve when a dispute occurs. Proper planning can make ownership transitions feel more like an evolution than a divorce.
How to Begin
Visualization is typically the first step. While it can be difficult to imagine the business without its original owners, the most successful businesses survive their founding partners. Owners should begin by mapping each possible succession sequence. Partners can then conceptualize ideal outcomes for the buy-sell agreement.
Buy-sell agreements are highly adaptive and customizable. Professional advice is therefore critical at the outset. A competent advisory team can help owners value the business and contemplate potential scenarios. Professionals can also guide partners through funding mechanics, tax implications, and any legal considerations (see: Connelly v. United States).
Securing a buyer is only the first step in exiting a business. Each partner should also update their own financial and estate plan. Buyouts and sales can unlock unprecedented liquidity for owners and their families. It is wise to protect and grow this wealth for the decades to come.
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