This Way Out: Buy/Sell Agreements and Business Exit Strategies
At the dawn of a new business, owners and entrepreneurs understandably focus their time and energy on laying the proper foundation and positioning their company for sustained success. Looking ahead years or even decades may seem like an unaffordable, premature luxury. But business owners who want to reap the rewards of their hard work and fund their retirements by cashing in their chips one day can’t afford to procrastinate.
How an owner exits a business can be just as important as how they enter it. That requires a thoughtful and thorough exit strategy, and the centerpiece of any exit strategy is a buy/sell agreement.
What Is a Buy/Sell Agreement?
Business owners must address and resolve many issues to successfully leave their management and ownership roles without causing disruption or conflict. A well-crafted buy/sell agreement provides clarity about:
- A method for valuation of the company and ownership interests acceptable to both owners and taxing authorities.
- Who can acquire ownership interests in the company and when.
- The order of precedence for the acquisition of ownership interests.
- How to fund the purchase of ownership interests.
A good buy/sell agreement will also:
- Provide a straightforward way to transfer ownership interests between family members and other owners.
- Establish a market for ownership interests that are otherwise not marketable.
- Protect business know-how, confidential information, and trade secrets upon transferring ownership interests.
- Restrict competition by prior owners upon transfer of ownership interests.
A Buy/Sell Agreement can take three primary forms: redemption, cross-purchase, or hybrid. A Buy/Sell Agreement often relies on a life insurance policy in the event of a death to facilitate that exchange of value. Some Buy/Sell Agreements have a predetermined buyout price, while others use a negotiated valuation formula or stipulate the hiring of an independent appraiser.
Redemption Agreement
In a redemption agreement, the owners agree to sell their interests to the business when an owner leaves the company, whether due to retirement, death, or disability. With the company buying out the departing owner, the proportionate holdings of each remaining owner are effectively increased, assuring that no owner acquires any more power or a majority ownership interest in the company.
Cross-Purchase Agreement
As opposed to a redemption agreement in which the company itself purchases the departing owner’s interests, a cross-purchase agreement allows a company’s other owners to purchase the interest or shares of an owner who dies, becomes incapacitated, or retires. Cross-purchase agreements are best suited to businesses with no more than two owners. That’s because they typically require each owner to take out life insurance policies on each of their partners, something that is both costly and administratively burdensome. Cross-purchase agreements may also have better tax consequences to the individual owners compared with the use of a redemption agreement.
Hybrid Agreement
A hybrid agreement is more flexible than a redemption or cross-purchase agreement and gives the business the first right to buy the departing (or departed) owner’s interest. If the company cannot or will not purchase the entire interest, the remaining owners can acquire any remaining interest.
Hybrid agreements are sometimes called “wait and see” agreements because they allow the company and members to wait and see whether it makes more sense for the entity or other owners to purchase the departing owner’s interest.
Why You Should Make a Buy/Sell Agreement a Priority
The best time to prepare a buy/sell agreement is early on. Waiting until later to do so comes with many risks, such as an unexpected illness or death that leaves the business with unanswered questions and confusion about the rights and roles of the remaining owners. The absence of a buy/sell agreement also creates the potential for expensive conflict between individuals who may have divergent interests and views about the direction of the business or their respective purchase rights.