6 Critical Questions to Answer When Drafting Your Buy-Sell Agreement

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So, you have done it. Your lifelong dream of owning a business is now a reality. You are running a successful company. But have you considered what happens when you’re ready to retire? Or worse yet, what happens if there is an untimely death or invalidity of an owner? While it may seem like a distant reality, legacy planning for the business you’ve worked hard to build is an essential ingredient in running a successful long-term business. And that’s where a buy-sell agreement comes into play.

A buy-sell agreement is, in its most basic definition, a contract between business owners to provide succession of property. It is a critical tool that helps ensure that the business can continue to thrive as the organization and its owners grow and change.

Below are some of the key questions to consider when creating your buy-sell agreement.

Related: What is a buy-sell agreement and why is it vital to a successful partnership?

1. How will you finance the departures of the owners?

We often see that the departure of an owner can cause the organization to produce a large amount of capital for the owner’s purchase, which has the potential to put financial stress on the business. This can often be mitigated through stipulations in the purchase-sale agreement.

There are several ways to finance owners’ exits, including lump sum payments, installment payments, and gradual stock transfers. Transferring this risk to an insurance company can also mitigate the capital needed from the business or other owners. Working with a wealth advisor and attorney can be helpful in finding a good financing option for your organization.

2. How should you structure any insurance policies you have to finance a buy-sell agreement?

While this may seem unlikely, it is important to protect your business in the event of the owner’s death or disability. The two most common forms of financed buy-sell agreements are cross-purchase and entity purchase agreements.

Generally implemented in businesses with fewer owners, in a cross-purchase agreement, each owner buys an insurance policy for the other. This allows the surviving owner to finance a purchase using insurance proceeds and increases the survivor’s tax base. This can also help reduce any subsequent taxes due on a future sale of the business. In an entity purchase agreement, the company owns all the owners’ insurance policies and uses the proceeds to buy back the shares, which are then retired.

Related: Estate Planning for an Owner Dependent Business

3. How do you replace owners who have left?

Usually when the owners start out, the business is still going. Therefore, it is important that the purchase-sale agreement establishes the terms of the owner’s transition.

For example, who replaces this owner? What protections are in place for the person replacing this outgoing owner? How will the knowledge transfer work? All of these elements should be outlined in your purchase-sale agreement to help ensure that the business is not negatively affected by the departure of an owner.

4. How do you prepare for the unthinkable?

Despite the efforts that many business owners put into planning for the inevitable, the future cannot be predicted. The unprecedented Covid-19 pandemic has resulted in a major business slowdown and caused many business owners to review their buy-sell agreements. Some took advantage of the temporary decline in the value of their businesses and transferred them to trusts with a significantly lower valuation. Others temporarily adjusted valuation calculations and owner stipulations to keep the business safe while it “weathered the storm.”

Let’s say an employee wanted to buy your business during the pandemic. Under the existing valuation formula, the transaction would have occurred at a significantly undervalued price to the owner. A review of the business owner buy-sell provision in the operating agreement resulted in the addition of a section to allow normalization of earnings in times of temporary stress. We are seeing more and more agreements that include these types of “fail-safe” clauses to protect a business during unforeseen, usually temporary, events.

5. How will you evaluate your business?

Your purchase-sale agreement should describe how you value the business. There are a few ways one can value their business for sale or inherited property. Multiples of earnings before interest, taxes, depreciation and amortization (EBIDTA) are one way, but they are not the only way.

From book value to enterprise value, using the correct formula for your industry and organization is critical. It is also quite common to include a fail-safe provision that allows an independent valuation expert to appraise the business. And more importantly, as the company grows, it is essential to re-evaluate your valuation formula. Of course, it is not advisable to constantly change your valuation formula. However, if your company grows from 20 to 200 employees, it may be time to review your valuation method.

Related: Exit Planning for Modern Leaders: How to Determine the Value of Your Company

6. How will you create an exit-ready business?

Once you’re ready to retire and fully enjoy the fruits of your labor, it’s important that the transition set you and the organization you’ve worked hard to build up for success. Will you stay on the board? Will you pass the organization on to family or key employees? Will you sell the business? These are key questions to consider when creating the legacy terms in your buy-sell agreement.

Whether you’re a business owner you hope to sell soon or you want to build the business for many years to come, effective succession begins before exit occurs. Developing a high-quality buy-sell agreement is an important part of legacy planning. Answering these questions can help protect the integrity of the business you’ve worked hard to establish.

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