Why Buy-Sell Agreements Are Essential to Partnership Businesses

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Commercial
Jun 23, 2023
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Updated 
9:00 am
 
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The journey of business partnerships is dynamic and ever evolving. Partners might choose to pursue different paths or unforeseen circumstances could change the direction of their professional commitments. It is in these instances that careful planning becomes invaluable. One effective way to ensure business continuity, despite changes in partnership, is the establishment of a buy-sell agreement. This strategic tool facilitates the smooth transition of ownership shares from a departing partner to the remaining ones.

Decoding the Mechanism of Buy-Sell Agreements

At the heart of a buy-sell agreement is the 'right of first refusal,' which allows existing owners or the business itself the first chance to acquire the exiting partner's stake before it becomes available to a third party. This provision safeguards the business from potential disputes or conflicting interests that an unknown outsider might introduce.

In the absence of a buy-sell agreement, the remaining partners could face challenges or legal complications with the family members of a deceased or incapacitated partner. For instance, the spouse of a deceased partner might inadvertently become a partner, without having the necessary understanding or interest in the business.

A well-drafted buy-sell agreement ensures that the business remains under the stewardship of the original partners while providing an organized framework for buying out the shares of a departing partner. The agreement delineates the circumstances under which a partner can sell or transfer business interests, requires the remaining partners or the company to buy this interest, and sets a fair purchase price and other sale terms.

Buy-sell agreements might also include restrictions on the departing partner to prevent them from starting a competing business within a certain geographic area or timeframe, or to deter them from soliciting the company’s clients. Moreover, these agreements can be tailored to discourage partners from leaving the business solely for financial gains.

Financing a Buy-Sell Agreement

Often, remaining partners may not have sufficient immediate cash reserves to buy out the exiting partner's shares. Hence, buy-sell agreements usually incorporate a financing option, allowing the partners to make a down payment and pay the remaining amount over an agreed period.

Alternatively, life or disability insurance can fund buy-sell agreements, smoothing the transfer of shares from a deceased or disabled partner. Two types of agreements commonly facilitate this:

  • Cross-purchase agreements: suitable for partnerships with a small number of partners (typically two or three). Each partner buys a cash-value life or disability insurance policy on the other partners. If a partner passes away or becomes incapacitated, the remaining partners use the insurance proceeds to buy the shares.
  • Entity purchase agreements: ideal for larger partnerships. Here, the business buys insurance policies on each partner. In the event of a partner's death or disability, the business purchases the shares, which are then divided among the remaining partners.


Valuing the Business Interest

The valuation of the business plays a pivotal role in buy-sell agreements. Therefore, all partners must agree on a fair value for the business before drafting the agreement.

Several valuation methods can be used, such as the market approach, which takes into account the value of similar businesses, or the asset-based approach, which deducts liabilities from the fair market value of the business's assets to arrive at an adjusted net asset value.

It's advisable to engage a professional for a formal business valuation before formulating the buy-sell agreement. This valuation should be regularly reviewed and updated to reflect changing conditions that might affect the business's value.

Furthermore, the buy-sell agreement should be periodically reviewed to ensure its relevance to the evolving business landscape and the macroeconomic environment. A well-structured agreement should be flexible enough to accommodate these changes as they arise.

Be Proactive, Be Prepared

Partners may decide to exit the business for various reasons, and life events such as death or disability are unpredictable. Therefore, proactively creating a buy-sell agreement ensures you and your business remain prepared for any eventualities.

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