A buy-sell agreement is one of the most important legal documents a closely held or family business can hold, along with the legally necessary documents such as articles of incorporation and partnership agreements.

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Business owners involved in closely held corporations and noncorporate types of entities – such as proprietorships, partnerships or limited liability companies – should have a well-drafted buy-sell agreement in the event of death or disability of the owner or the owner’s wish to sell or transfer interest in the company.

A buy-sell agreement addresses how and when owners can sell and must sell their shares. A well-drafted buy-sell agreement also formulates valuation criteria. Without a buy-sell agreement, businesses face peril when owners die, become incapacitated, divorce, file bankruptcy, retire or decide to sell.

The consequences of not having a properly drafted buy-sell agreement in these situations can, and usually do, lead to expensive litigation and possible business failure.

The best time to make a buy-sell agreement for any business is before the first penny of income is generated. But a business can generate and agree to a buy-sell agreement once the business is in operation.

A buy-sell agreement provides for smooth transition of a business interest according to the Center for Financial, Legal & Tax Planning Inc., by:

  • Identifying triggering events
  • Specifying to whom or to what the business interest must be sold
  • Providing a mechanism to determine the purchase price
  • Providing a funding source
  • Establishing a valuation for estate tax purposes,

The basic forms of buy-sell agreements are stock redemption agreements, cross-purchase agreements and the mixed agreement.

A stock redemption agreement, also known as stock restriction agreement, provides for the purchase of an interest by the entity itself, as differentiated from an agreement between business associates.

A partnership redemption plan, referred to as an entity plan, provides for the partnership to retire the exiting partner’s interest under specific conditions. A corporate stock redemption plan, used in closely held corporations, provides for the corporation to redeem or retire the affected shares.

A stock redemption agreement requires corporate approval because the agreement involves the corporate entity repurchasing the affected stock. The stockholders approve and sign the agreement with the company. Usually the company has only one agreement approved by the company and signed by all stockholders.

The cross-purchase agreement takes the form of a contract among stockholders. The stockholders purchase an existing shareholder’s share of the business interest on an individual basis.

A cross-purchase agreement among partners/shareholders provides that if one of the partners exits, the remaining partners/shareholders will receive the exiting partner’s interest in exchange for the price specified in the agreement.

Proprietors may make similar agreements with key employees, while partners or shareholders in closely held corporations may make such arrangements with other partners or shareholders or key employees. Each shareholder or partner usually signs a separate agreement with every other stockholder or partner. The agreements do not have to be the same. Each is unique to the parties signing the agreement and is only between the parties signing that agreement.

Mixed agreements are the third type of buy/sell agreement. The entity is given the first option to purchase the shares of a stockholder. To the extent the shares are not purchased by the entity, they can then be purchased by other shareholders usually in direct proportion as the ownership. If the shareholders do not purchase all of the remaining shares, the entity may purchase the remaining stock.

In many agreements, there is a clause requiring either the entity or the remaining stockholders to purchase “all or nothing.” Therefore, stockholders and companies are banned from purchasing just enough stock to give them controlling interest in the company, according to The Center for Financial, Legal & Tax Planning, Inc.

Good things happen when you plan to have a buyout agreement that spells out the owner’s right and obligations when an ownership transition occurs.