Buy-sell agreements are a critical, yet often overlooked, succession planning tool for closely held business owners. They provide a source of liquidity to exiting owners and their families and help ensure the continuity of the business by retaining control in the hands of the remaining owners.
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A buy-sell agreement goes into effect upon the happening of specified “triggering events.”. The parties to the agreement may build one or more triggering events into their particular buy-sell agreement, depending upon the anticipated succession issues.
A redemption agreement allows the business entity to purchase the interest of a deceased or withdrawing business owner upon the occurrence of previously agreed upon “triggering event.”.
A buy-sell agreement is typically structured as either a cross-purchase agreement or a redemption agreement. A cross-purchase agreement is an agreement among co-owners to purchase each other’s business interests upon the death or other withdrawal of one or more owners from the business. These agreements typically specify a predetermined purchase ...
A triggering event can be either mandatory or optional. After the triggering events have been determined, the parties must determine whether they wish to provide that occurrence of the event makes purchase mandatory, or merely creates a right or an option to purchase under the buy-sell agreement. Like any other contract, the parties have freedom to negotiate the contract terms in a buy-sell agreement in order to reflect the specific needs of the business. There are three common rights that are negotiated in the context of buy-sell agreements, including: 1 mandatory purchase requirements; 2 “call”-type options; and 3 “put”-type options.
In the event that an involuntary transfer is a triggering event, insurance will not likely be available to fund the purchase. If the parties have entered into a cross-purchase agreement, insurance funding is accomplished by the business owners purchasing insurance on the lives of each participating co-owner.
As a result, many buy-sell agreements are funded with insurance. The type of insurance that is required will depend upon the triggering events specified in the buy-sell agreement itself. If a right to purchase under the agreement is triggered by the seller’s death, the buyer or business may fund the agreement by purchasing life insurance ...
A buy-sell agreement can be funded through cash in the business or through each owner’s personal funds, but most are funded with some form of life insurance, disability insurance or both. If business owners intend to exit or sell the business within a certain period of time, they could purchase term life insurance, which is usually significantly less expensive than permanent or whole life insurance. If there is no plan to sell a business, and the owners’ goal is to ensure that the business will continue after one or more of their deaths, permanent insurance will likely be a better option. One of the benefits of permanent insurance is that a policy owner can often take a tax-free loan against the cash value of the policy. This can provide liquidity in the case of divorce or bankruptcy, where the exiting owner is still alive and well.
In contrast to redemption agreements, cross-purchase agreements are contracts between the individual owners of a closely held corporation. In a typical cross-purchase agreement, each owner agrees to purchase the interests or shares of a deceased or departing owner at the price and terms agreed upon in the contract.
Redemption agreements are contracts between business owners and the business entity itself. Under a typical redemption agreement, upon the occurrence of a triggering event (often defined as death, disability, divorce, bankruptcy or retirement), the owner agrees to sell, or offer to sell, his or her interest back to the company. The company is obligated to purchase or redeem the shares at a price determined by the terms of the agreement. The terms of a redemption agreement, including what constitutes a triggering event and how an owner’s interest is valued upon redemption, can vary widely.