The Importance of Buy Sell Agreements for Entrepreneurs

How can a buy sell agreement protect my small business?

Entrepreneurs must navigate a number of challenges in order to achieve success in the marketplace. Along the way, it’s important not to lose sight of the importance of buy sell agreement in protecting the business. The goal is to specify how the ownership interests will be redistributed in the event of a sudden or planned departure by one of the owners. By having this document in place the surviving owners have a legal mechanism which will enable them to redeem the stake of the departing owner.

Buy Sell Agreements in a Nutshell

Generally, there are three kinds of agreements for transferring ownership interests in a small business. The first is typically used by businesses with a small number of owners, a cross-purchase agreement. In this arrangement, the departing owner’s shares are purchased directly by the surviving owners.

On the other hand, some entities are better served by setting up a stock-redemption agreement in which the corporation redeems the departing owner’s shares. In this situation, the remaining owners do not acquire additional interests, but rather, the value of their shares increases.

Lastly, there are also “hybrid” buy sell agreements that combine the features of cross purchase and stock redemption agreements. In this scenario, the remaining owners retain the right to redeem the departing owner’s shares in the event that the business is unable to do so.

How is the value of the business determined?

A well-designed buy sell agreement will also specify how the value of the business will be determined, whether through the asset approach, the income approach or the market approach.

Determining value by utilizing the asset approach is simply a matter of evaluating the stated assets and subtracting the business’ liabilities. This approach does not consider present or future market conditions or good will. In the income approach, the value is arrived at by evaluating past and projected future earnings, in addition to future cash flow and capitalization. This allows for the present and  future value of the business to be determined. Finally, the market approach considers the value of the business by analyzing the sale of similar entities in the same industry, based on a number of variables including, but not limited to, market risk.

The Bottom Line

In sum, it is essential to have a buy sell agreement in place to plan for a number of unplanned events that can disrupt the business operations.  In a partnership, for example, the pending divorce of one of the partners can jeopardize the other ownership interests if the divorcing owner does not have a prenuptial agreement in place. Likewise, in the event of the unexpected death of an owner, a surviving spouse or other family members may become stakeholders without a buy sell agreement in place.

In the final analysis, these situations and the resulting confusion can be avoided with the help of an experienced business law attorney who can negotiate and prepare a buy sell agreement for your enterprise.