By Trent Derrick, CMT®
If you have ever wondered about what will happen to your small business when you retire or pass on, you are not alone. In fact, only 21% of business owners have a written plan for what an ownership transfer would look like. (1) It can be difficult to find the time or energy to put together an exit plan, but it is a crucial part of making sure your business will continue in your absence.
Whether it be passing the company to your business partners or your family, proper planning and a thorough buy-sell agreement are absolutely necessary to ensure all parties are covered. Here is everything you need to know about buy-sell agreements and how they can be used to protect your business.
What Is a Buy-Sell Agreement & Why Is It Necessary?
A buy-sell agreement is a legal contract between two or more parties that specifies what happens to a partner’s share of the business if they should die, become incapacitated, retire, or otherwise leave the firm. Most often, it will stipulate that the outgoing partner sell their stake back to the remaining partners, instead of to an outside party or family member. It is used as a way to prevent the business from being liquidated or sold to unwanted individuals.
A well-drafted and fully funded buy-sell agreement will allow for business continuity, ensuring that your departure doesn’t cause unnecessary disruptions or financial difficulty. It will also provide for your family financially in the event you can no longer work.
Whatever the case may be, it is important to make sure the agreement is properly funded so that the remaining parties will have the cash flow available to purchase your stake. If not, the business may pass to heirs who are unwilling or unable to operate it, leaving your business legacy at risk.
Types of Buy-Sell Agreements
There are several different types of buy-sell agreements to consider, including:
1. Cross-Purchase Agreement
In a cross-purchase agreement, each partner agrees to buy out the other's respective shares of the business when a triggering event occurs (i.e. death, disability, retirement, etc.). With this approach, each partner will typically buy a life insurance policy on every other partner as a way to fund the purchase of the outgoing partner’s share.
This structure gets more complicated as the number of owners increases. For instance, in a business with six owners, each one has to own and maintain five life insurance policies (one for each remaining partner). This would mean a total of 30 policies! For this reason, cross-purchase agreements are typically recommended for businesses with 3 or fewer partners.
2. Redemption Agreement
This type of buy-sell agreement is also called an entity plan or liquidation agreement. It is structured in a way that can solve some of the complexities of the cross-purchase agreement. Instead of each owner personally buying out the departing owner’s share, the business itself buys them out. There is only one life insurance policy needed for each owner’s life and the business is the owner of the policy.
3. Hybrid Agreement
Hybrid agreements are a combination of a cross-purchase plan and a redemption agreement in which both the remaining owners and the business itself buy back the departing owner’s share. The agreement will specify how much each party will purchase and at what price. It can also be structured in such a way that the business gets the option to buy the entire share first and the partners are offered the sale only in the event the business declines, or vice versa. Either way, a hybrid agreement can offer more flexibility than the traditional cross-purchase or redemption plans.
4. Third-Party Agreement
A third-party agreement is simply a contract between the business owners and one or more individuals or entities who are outside the current ownership group. If a triggering event should occur, the ownership rights would be sold to the third party per the terms of the contract. This can be used if there is no one within the business or your family who is willing to take over ownership.
Start Planning Today
If you have a small business, don’t wait to get your exit plan in order. Just as individuals need to properly plan for their estates upon death or disability, business owners need to plan for their company’s estate too. If you’d like to learn more or explore your exit plan options, book a consultation with me here or email me at email@example.com to get started today.
Trent Derrick is a financial advisor and Chief Market Technician at Legacy Wealth Management. Trent is passionate about the value small businesses bring to their communities and specializes in serving small business owners by providing seamless financial advisory services tailored to their financial needs, including tax planning, cash flow management, retirement planning, and bookkeeping. Trent has a bachelor’s degree from the College of Charleston and studied economics at the University of South Carolina, Columbia. He is a Chartered Market Technician® (CMT®) professional. Trent serves as a guest lecturer for the College of Charleston’s MBA program and acts as chairman of the Market Technician Association’s Charleston chapter. When he’s not working, Trent, a proud Eagle Scout, enjoys volunteering with the Charleston Animal Shelter’s outreach program. Trent and his wife love to cook international cuisines and host dinner parties with their friends. To learn more about Trent, connect with him on LinkedIn.