Business Succession Planning: Why Have a Buy Sell Agreement? – Summer 2018

If you are part owner of a business, you don’t need a buy sell agreement, but you should want one …

Sarah and James have worked together for many years as equal co-owners of a donut business. They have a great working relationship, with Sarah as the number’s person and James in charge of sales and production. One morning Sarah gets a phone call from James’s wife, Amy, telling Sarah that James has died in an automobile accident. They have no buy sell agreement and James’s will leaves everything to Amy. So,

  1. Sarah is now in business with Amy, who cannot do the work her husband had done. Sarah and Amy will have to hire a salaried replacement for James. As a result, Sarah probably will earn less for the same work.
  2. Sarah will be relying on Amy’s cooperation, but if Amy is not experienced in the business, achieving that cooperation could be time consuming or difficult.
  3. It may make sense for Sarah to buy Amy’s share of the business. ut, even if Amy is willing to sell, Sarah and Amy may disagree on price or payment terms. The time and tension that may be associated with the buyout would be a major distraction for Sarah while she tries to continue the business. Also, it is unlikely that Sarah has any dedicated source of funds to use for the purchase, which may make payment a challenge.
  4. Alternatively, Sarah may think it best to sell the business to a third party, and Amy may disagree on whether to sell or appropriate terms of sale.

If James and Sarah had a written buy sell agreement in place, Sarah’s right to purchase the business and the terms of purchase, as well as funding methodology, would have been established. There would be no unnecessary arguments or tension between Sarah and Amy.

Whether or not there is a buy sell agreement, Sarah, the business, or both might have purchased an insurance policy on James that could be used to fund the purchase or to provide cash for the business to hire a replacement for James (“key man insurance”). However, life insurance on an owner that isn’t key man insurance in most cases is purchased in the context of a buy sell agreement.

If they had a buy sell agreement, James and Sarah would have likely used a cross purchase agreement, where one owner buys out the other. Alternatively, they might have arranged for the business to purchase the deceased owner’s interest utilizing a “redemption” agreement, or some combination of a cross-purchase and redemption. Which type of agreement to use is very fact specific because of tax and other considerations.

A written buy sell agreement as part of business succession and estate planning of a business owner can make an unexpected transfer of a business interest much smoother and make planning easier. However, each owner must decide whether it is better to plan in advance or wait until a triggering event (e.g. death, disability or retirement) for negotiation of the terms for transfer of his or her business interest. Whatever the decision, it is important to explore alternatives and likely outcomes.

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