Which Type of Buy-Sell Agreement is Right for Me?

Buy-sell agreements can be set up for companies with one owner or many. The size of your company will affect your choices in setting up your specific form of buy-sell agreement and may cause one form to be more appropriate than another.  Just as there are different business ownership arrangements, there are different forms of buy-sell agreements. One of the distinguishing features between the different buy-sell agreement forms is the buyer to the transaction. The buyer could be any or all of the current co-owners, an outside third party, or the business entity itself. There can also be more than one buyer.

The following table illustrates the various types of buy-sell agreements that are commonly found. Within the basic forms of agreement, you can custom-fit your buy-sell agreement to your particular business through the use of various clauses, options, and requirements.

Overview of Buy-Sell Agreement Forms

What are the tradeoffs of having a buy-sell agreement?

In exchange for the guarantee of a buyer for your business interest, you must accept certain restrictions on your ability to transfer your interest to parties outside the agreement. Careful structuring of your buy-sell agreement and coordinating it with your personal estate and tax planning goals can minimize and possibly eliminate the impact of the following tradeoffs.

Restrictions can affect personal estate planning

Gifting strategies are important estate planning tools for owners of closely held businesses. Lifetime gifts of your interest in the business to your children could be part of your estate planning strategy to pass your business interest to your heirs and reduce the total value of your estate. Restrictions in the buy-sell agreement could prevent you (and your co-owners) from passing all or part of your interest in the business as a gift. The parties to the agreement, therefore, must consider whether to restrict transfers by gift.

Tip: If the ownership group decides to allow gift transfers, the group of permissible donees should generally be defined. The donee group should probably be subject to the terms of the buy-sell agreement.

Restrictions could limit your access to outside credit

Restrictions within the buy-sell agreement could prohibit you from pledging your own interest in the business as collateral for outside credit, or could require the consent of the other owners. Without the ability to pledge your business interest, the lender might turn you down for a loan.

Tip: If the buy-sell agreement is set up to include a right of first refusal, the owners would be allowed to pledge their individual business interests as loan collateral. If a foreclosure occurs, the stock acquired by the creditor would have to be offered for sale to the other parties to the agreement before it could be sold to a third party. Under the right of first refusal, the buyer under the agreement would have the right to buy (or refuse to buy) the shares held by the creditor. The lender must be notified the shares are subject to a right of first refusal, and the loan could not exceed the shares’ fixed purchase price. This restriction should be indicated on the stock certificate (many states have laws requiring this).

Restrictions may be unenforceable under state law

State property laws favor the right of business owners to transfer their interest in a business to whomever they want, whenever they want, at whatever terms they want. Restrictions in a buy-sell agreement that are extreme will generally be viewed as unreasonable and therefore unenforceable. For instance, a restriction that may be viewed as extremely prohibitive (and therefore unreasonable) is one that permanently and absolutely bans lifetime transfers of shares of a business’s stock, along with a mandatory resale of the shares to the corporation at death for the original purchase price. A restriction like this could be viewed as a forfeiture; unreasonable, and therefore unenforceable. If the only condition for a profitable transfer of stock is a pure right of first refusal that requires the offer of the stock at the same price to the other parties, it does not restrict the transfer of stock, only the persons who may buy the stock. In this case, the restriction is not extremely prohibitive and would almost always be enforceable.

In general, if the terms of the restrictions were reasonable when the agreement was executed, such as rights of first refusal and rights to buy interests in the business based on a formula set price, then the restrictions would be enforceable. Whenever a buy-sell agreement is ambiguous, the courts will not uphold the enforceability of the restrictions. However, a carefully drafted, clearly outlined buy-sell agreement containing reasonable terms of restriction should be able to avoid any issues with state law.

Choosing the right type of buy-sell agreement

A buy-sell agreement can be a powerful tool in a business continuation plan. When coordinated with your estate and tax planning, a buy-sell agreement can provide a smooth transfer of your ownership interest. In addition to looking at your own personal goals for estate and tax planning, you must consider factors specific to your business before you can decide on a particular type of buy-sell agreement.   Work with your attorney and tax advisor to draft an agreement that meets your goals, covers the necessary bases, and works with your estate and tax plans.

This material has been prepared solely for general  informational purposes, and it does not constitute tax, legal, or accounting advice. Nor does it represent, in any manner, a solicitation, offer, or endorsement of any banking or financial product, a guarantee of any future financial outcomes, or specific investment advice. Please consult with your own tax, legal and accounting advisor before engaging in any transaction.

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