The Purpose of Buy-Sell Agreements
For illustrative purposes, imagine yourself in partnership with two associates. The other two partners are Bob and Elaine. If Bob dies, his business interest passes on to his estate, and ultimately to his wife, Megan. Unfortunately, Megan knows nothing about the business. You and Elaine do not want to form a new partnership with Megan as a business partner, and you don't want Bob's interest sold to an outsider.
It should be added that Bob and Elaine face the same dilemma regarding your heirs. Fortunately, if a buy-sell agreement is in place, none of these potential problems will arise. All the owners know who will receive the deceased owner's business interest as well as how much will be paid for that interest.
A properly drafted buy-sell agreement:
- minimizes the possibility that the business might fall into the hands of outsiders
- minimizes the possibility that the parties involved will not be able to agree on a proper value for the business and puts everyone on equal footing while all the parties are alive
- minimizes the possibility that funds will be unavailable to make the purchase
- provides a deceased owner's estate with needed liquidity by converting an illiquid asset into cash.
It's easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner's heir(s).
Entity Buy-Sell Agreements
Under an entity or stock redemption agreement, the business agrees to purchase a deceased owner's interest. To help fund the agreement, the business purchases life insurance on the life of each of the owners; the business owns the policies and is the beneficiary of each policy. The face amount of each policy approximates the purchase price for the insured's business interest. The purchase price is usually set in one of two ways:
- a definite fixed amount is stated in the agreement, or
- a formula is specified by which a definite price can be established.