As business owners, you face an onslaught of obstacles everyday. You don’t have the luxury of just showing up to work and getting paid. You make it all happen, and you move the world to do it. A buy-sell agreement takes a few of the biggest obstacles you might face, and gets rid of them completely. Below is a detailed explanation of buy-sell agreements, and what they’re used for.
Note: this does not constitute legal advice. We work with competent legal professionals to design, develop and place buy-sell agreements for each of our clients that may need one. The following information is for informational purposes only.
What is a buy-sell agreement?
A buy-sell agreement is a legally binding contract between partners of a business that specifies how ownership in the business can be exchanged. There are various reasons ownership in a business might change, but a few of the most common reasons are listed below:
A partner decides to voluntarily leave the partnership
A partner dies
A partner becomes disabled
A sole proprietor wants to pass on business to another
Etc.
Regardless of what the specific reason is for setting up a buy-sell agreement, having one in place specifically protects ownership interest within the partnership. With an agreement in place, only those that the partners want to have ownership, can have ownership. Partner A won’t find himself in business with Partner B’s spouse, if Partner B dies.
Other companies that don’t have an agreement in place could run into problems because a deceased owner’s interest would pass on to a spouse. This can cause a number of issues more than just being in business with someone that can’t offer any expertise. The spouse may want to sell his/her ownership at an inopportune time—and a business losing a partner almost always creates an inopportune situation.
Another purpose of a buy-sell agreement is to stipulate how a business’ fair market value is determined. There are a number of reasons this is important. The first of which is that it protects a business from having to potentially pay out more money to buy a partner out than the numbers would dictate. People tend to inflate in their minds how much a business is worth, especially when looking to receive a cash payout. Being able to refer back to the agreement to determine that number can save the company a lot of money.
Another protection offered by a buy-sell is similar to what has already been covered—when a spouse comes to collect cash buyout of his/her spouse’s share in the business. Because the document is legally binding, the current partners can point back to the formula dictated in the agreement. There’s no ambiguity and no ability for either part to take advantage of one another.
How does it work
Generally speaking, buy-sell agreements are put in place by legal professionals and funded by life insurance (and/or disability insurance); though, they can be funded in other ways. Typically, insurance policies are bought on the lives of the owners, and if one of the owners dies, becomes disabled or leaves the business—their share is bought out by the incoming funds triggered by the event. As you can imagine, there is more than one way to accomplish this.
There are several different types of buy-sell agreements; we have listed a few in the subsections below. Again, none of these are legal definitions, but they are meant to explain the general concepts of how each works.
Cross-purchase agreement
A cross-purchase buy-sell agreement is one generally employed by very small companies of one or two owners. In these types of agreements, each owner buys an insurance policy on the life of every other partner. That policy will be the main source of funds to use to buy back the departed owner’s share. The more partners there are, the more complicated this gets. That’s why a different form of buy-sell agreement is usually used for larger companies.
Entity Purchase/Entity Redemption agreement
An entity purchase buy-sell is another commonly used type of agreement, and it simplifies the equation quite a bit if there are more than one or two partners. In an entity-purchase, buy-sell agreement the business will purchase ownership interest from a deceased, disabled or departed partner—instead of the partners doing it directly. This usually comes in the form of the business buying one life insurance policy on each partner’s life. If a partner dies, the business receives the funds and buys the partnership interest from the deceased.
An entity purchase buy-sell agreement is a great way to ensure your business is protected, and has the money it needs when it needs it most.
Other Agreements
Obviously, like anything, there are other types of buy-sell agreements that aren’t one of the previously mentioned two. Though we won’t mention them here, be aware that an agreement that you set up probably won’t look exactly the same as one of these.
Why is a buy-sell agreement especially useful for construction companies?
Generally speaking a buy-sell agreement should be in force for any business with multiple owners. It not only protects the business itself and ensures that the business will continue to function the way it should; but it also eliminates the headache and stress of figuring it all out if a partner were to die. The agreement dictates how it all works, and life insurance funds the transactions.
Construction companies specifically can benefit from buy-sell agreements for similar reasons to what we’ve discussed in our Key-person Insurance Section. If you haven’t checked that out yet, it’s definitely worth looking into and implementing to protect your business. But the most important reason to have a buy-sell agreement in place in the construction industry is that it is inherently more dangerous. Obviously, many companies are big enough that the partners no longer work on the front line anymore, but many aren’t. If the owners do any of the physical labor with employees, having an agreement in place shouldn’t even be a question.
For those companies that are big enough that the owners mostly work in the office, a buy-sell agreement is important for different reasons. Specifically, a larger company naturally has more employees with a vested interest in the company doing well. Ensuring that the ownership, and consequently, the choices and direction of the company, isn’t negatively impacted by unwanted outside ownership decisions is imperative. It not only protects the company but the employees as well.
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