Picture this: You and your business partner have built a successful company together over the past decade. Then one morning, you get a devastating phone call – your partner has suffered a heart attack and passed away unexpectedly. Now what happens to the business? Does their spouse become your new partner? Can they sell their share to a competitor?
Business structures that involve multiple owners come with unique risks that sole proprietorships typically don’t have to face. One unexpected event, like the death, disability, or sudden departure of a business partner, can throw the entire operation into uncertainty.
That’s where buy-sell agreements come in. Whether you’re planning for a future sale or want to ensure you have a sound business succession or exit plan in place, a buy-sell agreement is something that every business owner should be familiar with.
Here, we’ll break down what buy-sell agreements are, why they matter, and the different ways you can structure and fund them.
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that outlines exactly what happens to the shares of a business when one owner passes away or can no longer participate in the business.
The buy-sell agreement specifies who can buy a departing or a deceased owner’s interest, at what price, and under what circumstances. These contracts are sometimes called buyout agreements, business wills, or business prenups because they plan for major life changes before they happen.
The primary goal of using a buy-sell agreement is maintaining business continuity while protecting everyone involved – the remaining owners, the departing owner’s family, and the business itself.
3 Dangers of Not Having a Buy-Sell Agreement for Your Business
Without a buy-sell agreement in place, you leave the future of your business open to chance. That means ownership could shift to people who don’t share your vision, disputes over value could drain time and money, and transitions could become messy at the worst possible moment.
- Unwanted Owners Taking Control
When an owner passes away or exits, their shares could end up with a spouse, children, or even a competitor. Without a buy-sell agreement, you may suddenly find yourself in business with someone who has no experience—or worse, no interest—in running the company the way you do. - Disputes Over Business Value
If there’s no pre-determined valuation method, disagreements are almost guaranteed. Departing owners (or their families) may demand more than the business is worth, while remaining owners may feel pressured to overpay. This can quickly lead to lawsuits and financial strain. - Chaos During Transitions
When ownership changes hands without a clear process, it can stall operations, damage relationships, and create uncertainty for employees and clients. A buy-sell agreement helps keep transitions orderly and can therefore protect the long-term stability of your business.
Having a buy-sell agreement in place gives you and your partners peace of mind, knowing the business will remain stable and protected no matter what happens.
Common Triggering Events in Buy-Sell Agreements
Buy-sell agreements activate when specific events occur that affect an owner’s ability to participate in the business. Death is the most obvious trigger, but there are several others to consider, including:
- Retirement
- Disability
- Bankruptcy or financial difficulties
- Voluntary departure
- Involuntary termination
Voluntary departure covers situations where an owner simply wants to pursue other opportunities. Involuntary termination might occur due to poor performance, criminal conviction, or loss of professional licenses required for the business.
Some agreements also include divorce as a trigger to prevent ex-spouses from becoming unwanted business partners. The key is to identify all scenarios that could disrupt your business and plan accordingly.
Types of Buy-Sell Agreement Structures
When you draft a buy-sell agreement (with a qualified attorney in your state), you can structure it to fit your specific goals based on the business size and number of owners. Each approach has different tax implications and administrative requirements.
Cross-Purchase Agreements
In cross-purchase agreements, the remaining individual owners buy the departing owner’s shares directly. This works well for smaller businesses with just two or three partners.
Each owner typically purchases life insurance policies on the other owners to fund potential buyouts. When someone dies, the insurance proceeds go to the surviving owners, who use the money to purchase the deceased owner’s shares from their estate.
One advantage of this approach for the surviving owners is that they receive a step-up in the cost basis of the purchased shares, which can potentially reduce future capital gains taxes when selling the business later.
Entity-Purchase (Redemption) Agreements
For businesses with many owners, cross-purchase arrangements become unwieldy because you’d need multiple policies for each person. That’s where entity-purchase agreements come in.
With entity-purchase agreements, the business itself buys the departing owner’s interest. The company owns and pays for life insurance policies on each owner, simplifying administration. Instead of six owners each needing five policies (30 total), the company just needs six policies.
The step-up in basis, however, will depend on the structure of your business. If it’s a pass-through entity, the remaining owners might be able to get a step-up in basis. This is not the case if the business is a C-corp.
Wait-and-See Agreements
If you’re not certain which of the two approaches above would be better for your business, a wait-and-see approach can ensure that you at least have something in place if a triggering event happens.
Wait-and-see agreements provide flexibility because neither the individual owners nor the entity is predetermined as the buyer. When someone needs to sell their interest, this type of buy-sell agreement specifies a process for deciding who makes the purchase.
This might involve giving individual owners the first right of refusal, with the company stepping in if they decline. This flexibility can be valuable, but it requires more detailed planning to avoid confusion when decisions need to be made quickly.
How to Choose a Valuation Method for Your Business Interests
Determining a fair price for business interests is one of the most critical aspects of any buy-sell agreement. There are several different methods to value your business— the one you choose should be based on your company’s unique characteristics and industry.
Fixed price agreements set a specific dollar amount for each owner’s interest. While simple, these require regular updates to remain accurate as your business grows or market conditions change. Many agreements using this method become outdated quickly.
Formula-based valuations use financial metrics like revenue multiples, earnings multiples, or book value calculations. These automatically adjust based on the company’s performance, but the formulas must be carefully crafted to reflect true business value.
Professional appraisals provide the most accurate valuations but can be expensive and time-consuming.
Some buy-sell agreements require appraisals only for certain triggering events, like retirement, while using formulas for others like death or disability.
How to Fund a Buy-Sell Agreement
Because the timing of the triggering event is often unpredictable, it’s important to have a plan for funding the actual purchase when the time comes. Most business owners don’t have hundreds of thousands of dollars sitting in cash accounts, so they often prepare by using one of the methods below.
Life Insurance for Business Owners
Life insurance is a popular funding mechanism for buy-sell agreements because it creates instant liquidity exactly when needed. The death benefit provides tax-free cash to purchase a deceased owner’s interest without forcing the business to take on debt or sell assets.
For cross-purchase agreements, each owner buys policies on the others. In entity-purchase structures, the company owns policies on all owners. The premiums are often tax-deductible business expenses, making this approach cost-effective.
Disability insurance can also fund buyouts when owners become unable to work.
Alternative Funding Methods
Other ways to potentially fund the purchase of the departing owner’s business interests include installment payments, business loans, or cash reserves.
Installment payments spread the purchase price over several years, reducing the immediate financial burden. The downside is that this keeps the departing owner (or their family) tied to the business longer than they might prefer.
While business loans may provide immediate funding, the remaining owners must be confident in their ability to service this debt while maintaining operations.
Cash reserves work for smaller buyouts but require significant planning and discipline to maintain adequate funds. Most businesses prefer to invest excess cash in growth opportunities rather than keeping it idle.
Buy-Sell Agreement Examples in Practice
To illustrate how buy-sell agreements work, let’s take a look at a few examples with different types of businesses.
Consider a successful accounting firm with three equal partners, with the business valued at roughly $1.5 million. Their cross-purchase agreement includes life insurance policies worth $500,000 on each partner. When one partner dies unexpectedly, the survivors receive the insurance proceeds and purchase the deceased partner’s shares from his estate. The widow receives fair compensation for her husband’s interest, while the firm continues operating smoothly.
In another succession planning example, a manufacturing company with five owners uses an entity-purchase structure. When the founder decides to retire, the company’s life insurance policy provides part of the funding, with the remainder coming from installment payments over five years. This allows for an orderly transition while preserving cash flow.
A technology startup includes divorce provisions in their agreement after one founder’s messy separation nearly disrupted operations. When another founder later divorces, the agreement prevents the ex-spouse from claiming business ownership, protecting the company’s intellectual property and strategic direction.
Integrating Your Buy-Sell Agreement with Your Estate Planning
Buy-sell agreements should be a consideration in any comprehensive exit and estate planning for business owners, especially for businesses with two or more partners. These agreements can complement your wills and trusts by providing specific instructions for business assets that general estate planning documents often can’t address adequately.
Taxes are another big piece of the puzzle. The way your agreement is structured can have a major impact on estate taxes and how much your family (or your partners) ultimately receive. Properly designed agreements can help minimize estate taxes while ensuring fair compensation for departing owners’ families.
Because the tax and legal details can get tricky fast, it’s worth bringing in the right team. Working with an experienced attorney, accountant, and insurance professional can give you confidence that your buy-sell agreement not only protects your business but also fits smoothly into your estate plan.
Take The Next Steps to Protect Your Business & Family
Too many business owners put off creating a buy-sell agreement until someone is sick, retiring, or already out of the picture—and by then, it’s often too late. The best time to draft buy-sell agreements is when everyone is healthy, on good terms, and thinking clearly about the future.
It’s also important to involve the right people from the start. Spouses should understand how these agreements affect their financial security, and key employees should be aware of succession plans that may impact their careers. The smartest move you can make is to start the conversation now, work with qualified professionals, and review your agreement regularly as your business grows.
Get the guidance to ensure your personal and business financial plans are on the right track by scheduling your complementary call with one of our financial advisors in Tampa and nationwide.
Disclosure :
Jaffe Tilchin Investment Partners is a Registered Investment Advisor. Certain representatives of Jaffe Tilchin Investment Partners are also Registered Representatives offering securities through APW Capital, Inc., Member FINRA/SIPC. 100 Enterprise Drive, Suite 504, Rockaway, NJ 07866 (800)637-3211 Check the background of this firm on FINRA’s BrokerCheck
