When people come to me with their idea for a business, one of the first things I bring up is the buy-sell agreement. Perplexed, my clients ask why I want to talk about selling a business before it’s even come into existence. The answer is, because a buy-sell agreement operates like a prenuptial clause, and in this case, the marriage is the business itself. If a fledgling company is forced to divide its assets, it is likely to go out of business. To make sure that the business can continue to exist even if one partner wants to leave and do something else, a buy-sell agreement is a must. A buy-sell agreement operates as a fail-safe for businesses. It is placed within the company’s operating agreement, and clearly states the terms for how a partner/member/owner can leave a business and sell their interest.
The buy-sell agreement prevents an owner from selling his/her interests to an outside third party without the consent of the other owners.
The buy-sell agreement usually takes one of three forms:
- Entity-Purchase Agreement: This form involves an owner withdrawing from the business, agreeing to sell his interest to the entity itself, which then retires the ownership interest.
- Cross-Purchase Agreement: This form involves a withdrawing owner agreeing to sell his interest to the remaining owners. It’s fairly straightforward, and usually the most suitable choice for a small business with a handful of owners. If it is a larger business, with many owners, an entity-purchase agreement might be more suitable and less complicated.
- Hybrid Agreement: This form of buy-sell agreement is a combination of both of the previously mentioned options. Typically, the withdrawing owner must first offer his/her ownership interest to the entity. If the entity rejects the offer, or cannot meet the purchase price, then the shares must be offered to the other owners.
In any proper buy-sell agreement, besides the manner in which the interest must be sold, it must also describe the method in which the interest will be valued, and by whom.
The three most common methods are:
- Fair market value
- Book value.
- Formula Approach