Your Small Business Might Need a Buy/Sell Agreement

Buy/Sell agreements are used by businesses to ensure that a business interest of a departing, disabled or deceased owner is transferred to the co-owner(s) or the business itself according to preset and agreed upon terms. It may also be referred to as a buyout agreement, and the main reason a business needs one is because business relationships, like personal ones, can be hard and unpredictable. Having a buy/sell agreement can help owners avoid potentially difficult situations down the road.

A good way to think about a buy/sell agreement is that it's a prenup between the company owners. It outlines how remaining owners will purchase the shares from an owner upon certain events occurring (common ones are bankruptcy, death, retirement, or an owner simply wants out). It lets co-owners decide how their ownership stake can be sold, including the price and to whom it's sold.

The agreement can be tailored to meet the specific needs of individual businesses, but the key aspect to remember is making sure that there is a mechanism in place to pay the buyout price. Below are 4 common ways to fund a buy/sell agreement:

1. Cash Fund - basically it's creating a savings account with cash that would be used as payment should a buyout situation arise. The problem that often occurs here is it's hard to know when or how much cash will be needed, which inevitably leads to cash funds being inadequate to cover the buyout price.
2. Borrowing - it's pretty straight-forward: you get a loan to cover the cost of the buyout. However, there is the risk of not being able to find a bank to loan the money, or not getting favorable terms on the loan, which could negatively impact company cash flow.
3. Installment Payments - this too is pretty straight forward: pay the buyout price over a period previously agreed to in the buy/sell agreement. Lots of potential risk for a departing owner here since the business may fail, or not generate enough cash to make payments over an extended period of time.
4. Insurance - life insurance or disability insurance can be purchased on owners in order to fund a potential buyout. There is the cost of paying the premium, and insurance may not cover all of the potential buyout scenarios, but it can often be used in some combination with the 3 options above to offset some of their risk.

Small business owners should seriously consider some form of buy/sell agreement, it's in the best financial interest of the company and can provide some piece of mind in the event an owner has to be bought out.