What is a buy‑and‑sell agreement?
– A buy‑and‑sell agreement (also called a buyout agreement, business will, or business prenup) is a legally enforceable contract that sets out how an owner’s share of a company will be transferred if that owner dies, retires, becomes disabled, or otherwise leaves the business. Its purpose is to keep outsiders from acquiring an ownership stake, to provide a method for valuing the departing owner’s interest, and to provide a funding mechanism for the buyout.
Key terms (defined)
– Estate: the assets and liabilities a person leaves behind at death.
– Probate: the court process that administers a deceased person’s estate.
– LLC (limited liability company): a common business structure that combines elements of partnerships and corporations.
– Death benefit: the amount paid by a life insurance policy when the insured person dies.
– Valuation: a method or formula specifying how the business (or an owner’s share) will be priced.
How a buy‑and‑sell agreement typically works (step‑by‑step)
1. Owners agree on triggering events that will force or allow a sale of an owner’s shares (death, retirement, disability, bankruptcy, voluntary exit).
2. The agreement specifies who may buy the departing owner’s interest (the company itself, the remaining owners, or a mix).
3. The owners agree on a valuation method (fixed price, formula tied to earnings, periodic appraisal, or other mechanism).
4. The agreement lays out funding: many owners take out life insurance on each other so proceeds are available to buy shares on an owner’s death.
5. If a triggering event occurs, the buyer uses the agreed funding method to purchase the shares, and the seller (or seller’s estate) transfers ownership according to the contract terms.
Types of buy‑and‑sell arrangements
– Owner‑purchase arrangement: remaining owners buy the departing owner’s shares directly.
– Entity‑purchase (redemption) arrangement: the company itself buys back the departing owner’s shares.
– Mixed approach: some ownership portions are bought by the company and some by remaining owners.
– Wait‑and‑see agreement: the agreement does not name a buyer in advance; when a triggering event occurs it chooses the option (owner purchase or entity purchase) that best fits the situation at that time.
What to include in the agreement
– Triggering events that cause the agreement to apply.
– The buyer(s) (who must purchase the shares).
– The valuation method and timing for any appraisal.
– Payment terms (cash, installment, promissory note) and any security for deferred payments.
– Funding arrangements (life insurance policies, sinking fund, company reserves).
– Restrictions on transfers (right of first refusal, approval requirements).
– Procedures for dispute resolution and the timetable for closing the sale.
– How to handle minority interests and buyouts of partial ownership.
Advantages
– Prevents unexpected outsiders (for example, surviving family members who don’t wish to operate the business) from becoming co‑owners.
– Provides a prearranged way to value and transfer ownership, reducing conflict and litigation risk.
– Can
Can preserve business continuity by ensuring ownership transfers to capable or intended parties rather than unprepared heirs or unrelated third parties. It can also support estate planning, provide liquidity to families, and make valuation and timing predictable for all parties.
Disadvantages
– Cost and complexity. Drafting a comprehensive agreement typically requires legal, tax, and valuation professionals.
– Inflexibility. Fixed valuation formulas or funding mechanisms may become unfair as the business and market conditions change.
– Funding shortfalls. Life insurance, company reserves, or sinking funds may be inadequate when a buyout is triggered, leaving buyers with debt or sellers’ estates unpaid.
– Valuation disputes. Even with prearranged methods, disagreements over inputs (e.g., discretionary adjustments, normalization) can lead to litigation.
– Tax consequences. Different agreement structures create different tax outcomes for buyers, sellers, and the business; these depend on facts and jurisdiction.
Common types of buy‑sell agreements (defined)
– Cross‑purchase agreement: Remaining owners (the buyers) purchase the departing owner’s shares directly. Often used by a small number of owners.
– Entity‑redemption (stock‑redemption) agreement: The business entity buys the departing owner’s shares. Often simpler administratively when many owners exist.
– Hybrid (wait‑and‑see) agreement: Gives the business the first opportunity to buy; if it declines, the remaining owners may buy. Combines flexibility with multiple funding paths.
How to choose a structure (stepwise checklist)
1. Identify participants and triggering events you want covered (death, disability, retirement, divorce, involuntary transfer).
2. Decide who should buy (owners, entity, or both) for each trigger.
3. Choose valuation methods and frequency of mandatory appraisals.
4. Specify payment terms (cash, installments, promissory note, security).
5. Plan funding (life insurance policies—term or permanent—sinking funds, corporate cash, bank lines).
6. Draft transfer restrictions (ROFR = right of first refusal, approval thresholds).
7. Add tie‑breakers: appraisal procedures, dispute resolution (mediation/arbitration), and closing timelines.
8. Review tax, accounting, and creditor implications with professionals.
9. Update the agreement regularly (every 3–5 years or when ownership changes).
Worked numeric example — valuation and payment
Assumptions:
– Three equal partners; business value determined by EBITDA multiple.
– Last 12‑month EBITDA = $200,000. Agreed multiple = 4× EBITDA.
Valuation:
– Business value = 200,000 × 4 = $800,000.
– Each partner’s share = 800,000 ÷ 3 = $266,667.
Funding with a promissory note (annual payments)
– Buyer owes $266,667, interest rate 5% annually, term 5 years (annual payments).
– Annual payment formula for an amortizing loan: Payment = PV × r / (1 − (1 + r)^−n)
– Payment = 266,667 × 0.05 / (1 − 1.05^−5) ≈ 61,580 per year.
– Total paid over 5 years ≈ 307,900; interest ≈ 41,233.
Funding with life insurance (entity redemption)
– Company purchases a life insurance policy on each owner with death benefit = each owner’s share ($266,667).
– If death occurs, proceeds pay the company, which redeems the decedent’s shares.
– Premiums depend on owner age/health and policy type; plan for premium escalation and corporate deductibility limits.
Practical drafting tips
– Be explicit about valuation inputs (normalize earnings, define discretionary items).
– Include an appraisal mechanism and fallback if appraisers disagree (e.g., average of two appraisals or third‑party umpire).
– Give clear timelines for notice, closing, and payment to avoid liquidity gaps.
– Address partial ownership transfers and minority discounts if relevant.
– Coordinate the buy‑sell with shareholder agreements, operating agreements, bylaws, and estate plans.
Implementation checklist (who does what)
– Owners: agree on triggering events and who should be buyers.
– Lawyer: draft the agreement, ensuring enforceability under state law.
– Valuation professional: propose acceptable valuation methods and sample calculations.
– Insurance broker: price life insurance options if used for funding.
– Accountant/tax advisor: model tax consequences and cash‑flow impact.
– Board/owners: adopt and fund the plan; revisit periodically.
Tax and legal considerations (overview)
– Tax outcomes depend on structure. For example, in a cross‑purchase the buying owners generally receive a higher tax basis in their acquired shares; in an entity redemption the corporation’s purchase may not affect individual basis in the same way.
– Life insurance proceeds are usually received income‑tax‑free under U.S. federal law, but ownership and beneficiary design matter for estate tax and transfer‑for‑value rules.
– State law governs enforceability, so incorporate applicable statutory rules (e.g., corporate formalities, transfer restrictions).
– Always consult qualified tax and legal advisors
Valuation methods (practical overview)
– Fixed price (pre-agreed): parties set a dollar price or formula now and update it on a schedule (annually, every 3–5 years). Simple but can become outdated.
– Formula tied to operating metrics: common formula: Valuation = (EBITDA × multiple) − net debt. Define each term (EBITDA = earnings before interest, taxes, depreciation, and amortization; net debt = interest‑bearing debt − cash). Multiples should reflect industry norms and be reviewed periodically.
– Appraisal on trigger: use one or more independent appraisers to set fair market value when a buy/sell event occurs. Slower and more costly, but often viewed as the fairest.
– Hybrid or capped formulas: formula provides a baseline but appraisal can adjust upward (or down) subject to caps/floors.
Worked numeric example (EBITDA/multiple approach)
– Assumptions: EBITDA = $200,000; chosen multiple = 5; interest‑bearing debt = $200,000; cash = $0.
– Enterprise value = EBITDA × multiple = $200,000 × 5 = $1,000,000.
– Equity value = enterprise value − net debt = $1,000,000 − $200,000 = $800,000.
– If Owner X holds 40% equity, buy/sell price for X’s interest = 40% × $800,000 = $320,000.
Cross-purchase vs. entity redemption — quick numeric illustrations
– Setup: three equal owners (A, B, C). Total company equity value = $900,000; each 1/3 interest = $300,000.
Cross-purchase with life insurance
– Each surviving owner buys the decedent’s shares. If A dies, B and C each buy half of A’s interest: each pays $150,000.
– To fund purchases via life insurance, B and C could each own policies on A sized to pay $150,000 on A’s death. Owner B would own separate policies on A and C for the appropriate amounts.
Entity redemption with life insurance
– The company owns policies on each owner equal to that owner’s buyout amount. If A dies, the company receives $300,000 and redeems A’s shares from the estate directly.
Checklist: drafting and implementation items
– Define triggering events clearly: death, disability, retirement (with age/service definitions), divorce, bankruptcy, involuntary removal, voluntary sale, and material breach.
– Choose valuation method and revision schedule; include tie‑breakers for disputes (e.g., three‑appraiser method).
– Specify payment terms: lump sum, fixed installments with interest rate, promissory note, escrow, or earn‑outs.
– Address transfer restrictions and rights of first refusal/first offer.
– Decide funding mechanism: owner‑purchased life policies (cross‑purchase), company‑owned policies (entity redemption), uninsured installment financing, or hybrids.
– Draft procedures for execution and closing: notice requirements, timing, documentation (stock transfer forms, updated cap table, corporate resolutions).
– Tax and estate provisions: state whether purchase price steps up basis, who reports gains, and any withholding responsibilities.
– Contingency provisions: what if buyer cannot pay, if valuations lapse, or if insurer denies claim.
– Governance and amendment rules: who can amend, voting thresholds, and frequency of review.
Typical timeline on a triggering event (step‑by‑step)
1. Notice: trigger event occurs and notice is provided per agreement (e.g., 30 days).
2. Valuation: apply formula or order appraisal within a set period (e.g., 60–90 days).
3. Election/acceptance: buyer(s) must elect to buy within the specified window (e.g., 30 days after valuation).
4. Funding: confirm insurance proceeds or buyer financing; if installment sale, execute promissory note/security documents.
5. Closing: transfer shares/units, update books and issue stock certificates; record lien if seller carries paper.
6. Post‑closing: adjust tax basis records; file required corporate minutes and any required state filings.
Common drafting pitfalls and how to avoid them
– Vague triggers: define disability and retirement with objective criteria (e.g., SSA determination, inability to perform duties for X days).
– Outdated valuation formulas: build in mandatory review periods or formula collars.
– Ignoring minority/majority consequences: consider how buyouts affect control; include drag/tag provisions if relevant.
– Overlooking transfer‑for‑value and estate tax effects of life insurance: coordinate ownership/beneficiary design with tax counsel.
– Failing to plan for uninsured/illiquid situations: include installment terms, security interests, or lender consent mechanics.
Practical tips for implementation and governance
– Revisit agreement and funding annually or after material changes (e.g., new financing, major client loss, M&A).