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The advantages of a buy-sell agreement for small businesses

On Behalf of | May 15, 2023 | Business & Commercial, Commercial

When two or more individuals decide to establish a business, their first thoughts are about future profits and expansion of the business.

Unfortunately, not every business travels a smooth road into the future. Outside events, such as the divorce or bankruptcy of a shareholder, or an unresolvable conflict among shareholders about the direction of the business, can destroy the business if the shareholders do not have a plan for the repurchase of shares.

These difficulties can be ameliorated with a carefully drafted buy-sell or stock purchase agreement.

The basics of a buy-sell agreement

A buy-sell agreement specifies particular events that give other shareholders the right to purchase the shares of one or more of the other shareholders. These provisions are commonly called “trigger clauses.” A typical buy-sell agreement also specifies the price of the shares that will be transferred and the mechanics of paying for the shares.

In the discussion that follows, the owners of the company are referred to as “shareholders,” but a buy-sell agreement can be structured to apply to a partnership, a closely-held corporation, a limited liability company or any other business entity.

Examples of trigger clauses

The three most common events that can trigger a mandatory sale and purchase of shares are the death of a shareholder, the disability of a shareholder, or the divorce of a shareholder.

A shareholder divorce could result in the transfer of the shareholder’s interest in the business to the former spouse, thus injecting a new person and personality into the governance of the business.

Other triggering events could be the bankruptcy of a shareholder, a deadlock among shareholders concerning an important business issue for the company, business decline, or the destruction of corporate assets by a fire or natural catastrophe.

Determining the purchase price

Many buy-sell agreements contain a clause that sets a definite purchase price for the shares of the departing shareholder. This approach may prove unworkable as business conditions may significantly affect the price of the departing shareholder’s interest.

A better approach is to assign the job of setting the price for the interest being transferred to the company’s regular accountant or determining the price by appraisal or mediation.

Payment for the stock

A buy-sell agreement should contain a provision setting forth the mechanism for payment of the price to be paid to the departing shareholder. Many buy-sell agreements are funded by purchasing policies of key man life insurance on the lives of the shareholders.

Other options include a sinking fund that accumulates cash to pay for the interest of the departing shareholder or using future income to pay for the shares.

Conclusion

Regardless of the exact form of the buy-sell agreement, it should be drafted by experienced professionals. The buy-sell agreement should also be seen as a necessary part of the initial organization of the business.