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Even Business Partners Need a Prenup; It’s Called a Buy-Sell

May 15, 2015
Personal Finance
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By Doug Bend and Alex King

Learn more about Doug at NerdWallet’s Ask an Advisor

Many entrepreneurs decide to launch a small business because of the vision and passion they share with a longtime friend or colleague who then becomes their business partner.

But as with virtually any marriage or relationship, things can change, and you need to be prepared for that possibility – before the honeymoon is over.

A buy-sell agreement is a legal contract between the co-owners of a company that addresses a variety of business-changing events, such as if an owner dies, retires, becomes disabled or is booted out of the company.

When things get rocky

Just like a prenuptial agreement, a buy-sell is a roadmap that can be used if one or more partner decides to change course. Often, the agreement is drafted at a time when all parties are on friendly terms and in sync on where the business is headed. That should lessen the chances of a dispute if things turn sour or tragedy strikes.

When putting together a buy-sell agreement, the parties must decide which events will fall within the scope of the agreement and how each event will be handled.

Two of the more common triggering events include the death or permanent disability of a partner. Even a successful business may lack the cash necessary to buy out an owner’s interest after an unexpected death or disability.

In an effort to plan ahead, owners will often take out life and disability insurance policies on business partners. This way, if one becomes disabled or dies, the remaining owner or owners will have the necessary funds to buy out the partner’s interest.

An effective buy-sell agreement outlines how this will take place. In the absence of a buy-sell pact, a deceased partner’s ownership interest would pass to his or her estate, and the remaining owner could face a long and complicated legal process.

Other important provisions in a buy-sell include how each owner’s interest will be valued and what procedures will be in place if one owner decides to sell voluntarily.

What needs to be spelled out

An ownership interest in an LLC or a corporation is considered personal property, which means it can be transferred freely as long as there are no provisions in the company’s charter documents or imposed by law.

Having restrictions that force the departing owner to first offer his or her interest to the remaining owners provides a mechanism to ensure the ownership of the company stays in the hands of a select few.

For the agreement to achieve its basic objectives, the percentage of the company that each person owns—and the purchase price of each partner’s share—should be clear and unambiguous.

An effective valuation procedure should provide a means for determining the purchase price of a departing owner, whether the value is defined as an agreed-upon amount by the owners, a formula or through a method using a third party.

There are some factors to consider when drafting a buy-sell agreement. Here are a few key points for your company’s attorney, accountant and business partners to consider.

  • What are the potential sources of funding for purchasing an ownership interest?
  • Which partners will be included in the buy-sell agreement?
  • Will installment payments be considered for the purchase of an ownership stake?
  • How will the valuation process for each ownership stake be determined?

The final terms can vary depending on a number of factors, including the size and financial condition of the company, the health of the owners and the individual preferences of the partners.

Taking the time to plan now can help you avoid major headaches and disputes down the road.