Anyone who’s wrangled over the value of marital assets in a divorce understands the value of a well-drafted prenuptial agreement. For the same reason, closely held businesses with multiple owners need a buy-sell agreement. A buy-sell agreement is a legal document that spells out how to value ownership interests and how and when owners may sell those interests. More importantly, a buy-sell agreement can provide a source of funding for the purchase of an owner’s interest in the business in case of death or disability.
A “standard” buy-sell agreement may prevent the sale of an owner’s interest in the company to anyone but another owner, or require consent of all other owners to bring in a new owner. If an outsider makes an offer, there may be first rights of refusal that allow either the company or individual owners to match the terms of the offer.
In addition, a buy-sell agreement should provide for a valuation method to minimize disagreement over how much money an owner gets for his or her share of the company. Valuation methodologies come in all shapes and sizes, and some are more appropriate than others depending on the nature of the business. And while mathematical formulas relating to multiples of earnings offer a quick answer, it is rare if ever that a simple equation will correlate to the true “going concern” value of a company. For those reasons, many buy-sell agreements contain a default provision requiring the owners to hire a qualified business appraiser to value the business if the owners can’t agree.
The buy-sell agreement also may require a mandatory company buy-back of an owner’s interest in the business if the owner dies or becomes disabled. Typically, the buy-sell agreement will include language that lets the company purchase life or disability insurance on all of the owners to ensure sufficient cash to fund a company purchase. However, many companies don’t get around to buying the appropriate insurance policies, or they don’t update the value of the company regularly to know how much insurance is needed. In situations where an owner dies or becomes disabled, an unfunded buy-sell agreement isn’t much better than no buy-sell agreement at all.