5 Reasons Why Every Business Must Have a Buy-Sell Agreement

I recently got a call from a client with some good news, and some bad news.  I’ll call this client Joe. Business partners Fight, business divorce, small business divorce, buy-sell agreement, business breakup

The good news was Joe had recently gotten a prestigious job offer and that he would have to leave the company he co-founded with a couple of partners.

The bad news? Joe had just been diagnosed with cancer.

Fortunately, his prognosis was very good, and his doctors said with treatment he had an excellent chance of being back at work in no time. At the same time, the new company wanted Joe to divest all of his ownership interest in the old company as soon as possible so he could start work whenever he was feeling up to it.

Needless to say, there was a bit of urgency to the situation.

This wasn’t the first time Joe and I had discussed worst case scenarios involving his business.

Joe and I had actually had  a number of conversations over the years about the fact that he and his partners needed to revise the cookie cutter LLC Operating Agreement they had downloaded from an online service before I had met them.

The major issue in this case was the Buy-Sell agreement. A Buy-sell agreement spells out what happens when a member wants to or has to sell his or her interest.

In this case, Joe needed to sell his interest in the company because it would have created a conflict for him while he was working for this new company.

So he had to sell, and he had to sell quickly.

How Joe’s Situation Could Have Been a Disaster

We were fortunate in that Joe and his partners got along well. But that’s not always the case.

If Joe and his partners didn’t get along, or if one of the partners had died suddenly and the remaining partners were negotiating with a wife or children of their former partner over how much the deceased partner’s share was worth, it might be a different manner.

The whole situation illustrated why every company needs to have a strong buy-sell agreement:

1. To Preserve Good Relationships

Robert Frost famously wrote, “Good fences make good neighbors.”

A buy-sell agreement is the modern day equivalent of a “good fence” for partners in a business. A buy-sell agreement helps to define boundaries in advance so there is no confusion or misunderstanding between partners in the future.

Like a good fence, it’s always easier to agree upon where the fence should go, how high it should be, etc., in advance when everyone is getting along and no one needs to sell urgently.

2. Health Problems Happen

Just like my client Joe in the above example, a sudden health problem could force a decision on an issue.

Fortunately, Joe’s prognosis was good, but what if he was in a coma or had a heart attack? He might not be able to participate in discussions concerning the value of his interest, nor would he be able to communicate with his family members who might not agree with his partners’ determinations regarding value.

Imagine this scenario: you have two business partners who get along really well. Let’s call them Ben and Jerry.

Ben’s wife Angie can’t stand Jerry. She resents all the long hours Ben spent at the office working on the business and not at home spending time with her.

Then Ben dies suddenly, and Jerry is left negotiating with Angie over how much Jerry has to pay Angie for Ben’s share of the business.

Not only does Jerry have to find a replacement for Ben, and keep the business afloat, but Jerry also has to agree with Angie over how much he has to pay Angie and over what period of time (right away? 12 months? 5 years?).

Of course, Angie believes her share of the business is worth approximately a gajillion dollars, and she and Jerry can’t agree.  They can’t even agree on how to value the business.

It’s no easy situation.

3. Even if Members Get Along, They May Not Agree on Value

Even if the members of a LLC continue to get along as partners but one or more of them wants to be bought out, then they might not agree on the value of the company they have built. A buy-sell agreement can decide the method of valuing a company’s interest ahead of time, so that when it does come time to sell, there is a set formula.

So, for example, the partners can agree in advance that the company will be valued at two or three times annual revenues, or a valuation will be determined by an independent business valuation specialist.

By agreeing in advance, it tends to reduce the chance of conflict later.

4. A Buy-Sell Agreement Can Help Pay For the Departing Member’s Interest

Even if there is a buy-sell agreement which clearly spells out what happens if one member departs, a remaining issue can be how the remaining Members or the Company comes up with the money to buy the departing member’s interest. This is particularly an issue if one member dies suddenly, unexpectedly.

If the company has greatly grown in value, then it can be very difficult for the Company to come up with the funds to buy out the interest.

One option is for partners to purchase life insurance ahead of time on the lives of the other members. When a member dies, then the life insurance allows the Company to pay the deceased member’s heirs for the deceased member’s interest.

5. So the Company Doesn’t Go Broke

Just because one of the partners kicks the bucket doesn’t mean the Company should too.

OK, that’s kind of harsh, but you get the point. Most companies can’t immediately come up with the cash to pay out a departing member. Unlike Apple, most companies don’t have hoards of cash sitting around.

To avoid that problem, you can have the buy-sell agreement spell out what period of time the company has to pay out the departing member.

You can say that the Company has 3 years or 5 years over which the Company has to pay out the departing partner in monthly installments, giving the business time to come up with the funds from ongoing revenues.

The bottom line is a buy-sell agreement is like a premarital agreement. It sets the ground rules early so that everyone is on the same page when it comes time for the marriage to wind up.

 

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Photo credit: Microsoft office online

 

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