Understanding the Buy-Sell Agreement
Business owners with partners can protect themself by having a buyout agreement (aka buy-sell agreement) in place. This agreement allows stockholders to purchase partners' interest in the company under certain triggering events such as retirement, or death. The agreement can also be structured so that company partners have the first right to purchase the interest in the company.
The common type of buy-sell agreement are:
1.) Stock-repurchase agreement
2.) Cross-purchase agreement
The first one is commonly used in small businesses. It allows the company to buy out the departing owner's interest. For example, if one of the partners decides to leave the company, his or her stocks can be purchased by the company thereby increasing the share of other partners in the company.
A cross-purchase agreement is a bit different. Instead of the company purchasing the stock of the departing partner, remaining owners are allowed to purchase the departing owner’s stock.
Who needs a buy-sell agreement?
Any business with partners should have a buy-sell agreement in place. This agreement should be drafted and signed as soon as the company is formed. The agreement will protect the owner leaving the company along with partners remaining in the business. A buy-sell agreement can help businesses avoid costly conflicts when the buyout time comes.
What methods are used to set the price?
Pricing should be based on the evaluation of your business. This is where your CPA will come in. IRS section 2703 prevents a business owner from picking a random low value for the evaluation purpose due to estate planning laws. However, your CPA or lawyer should be able to help you come up with a fixed price agreement.
The better way to evaluate your business is to use the valuation process agreement. It is a good idea to engage an independent valuation analyst to determine the fair market value of the business. There is a good chance that a fixed value agreement may undervalue or overvalue your business. However, an independent valuation will get you much closer to the correct number.
You can engage an independent valuation analyst on a yearly basis to determine the correct value of your business and update your buy-sell agreement accordingly.
Do you have a buy-sell agreement for your business?