Buy-Sell Agreements: What They Are and How They Are Funded

A buy-sell agreement is a written contract between the owners of a business that sets what happens to an owner's share when that owner dies, becomes disabled, retires, divorces or simply wants out. It names who buys, how the price is set and where the money comes from. For closely held businesses in metro Atlanta, it is often the single document that keeps a family, the remaining partners and the company from ending up in a dispute at the worst possible time.

Why does a business need a buy-sell agreement?

Without one, an owner's share passes under his or her will or state law. The surviving partners may find themselves in business with a spouse or heirs who have no interest in running the company, and the family may own a stake they cannot sell. A buy-sell agreement settles those questions in advance, while everyone is healthy and on good terms.

What are the common types?

• Cross-purchase: each owner agrees to buy the departing owner's share. Simple with two or three owners; it gets complicated with more.
• Entity (redemption): the company itself buys back the share. One agreement and one set of policies, whatever the number of owners.
• Hybrid (wait-and-see): the company has the first option to buy, and the owners buy what the company does not. This keeps flexibility until the event happens.

Which structure fits depends on the number of owners, the type of entity and tax considerations your CPA and attorney will weigh in on.

How is the purchase price set?

Common methods are a fixed price the owners update each year, a formula (such as a multiple of earnings or revenue), or an independent appraisal at the time of the event. The weakest agreements are the ones with a price nobody has updated in years. We recommend an annual review, and an informal business valuation can be a starting point.

How is a buy-sell agreement funded?

The agreement says who buys; funding says how they pay. The four sources are cash on hand, borrowing, installment payments to the departing owner or family, and insurance. Life insurance on each owner is the most common way to fund a death buyout because the proceeds arrive when the obligation does, generally income tax-free, and the purchase does not depend on the company's cash or credit at a difficult moment. Disability buyout insurance works the same way for a long-term disability. Who owns and pays for the policies follows the structure: the owners in a cross-purchase, the company in an entity agreement.

When should it be reviewed?

Any time an owner joins or leaves, the business value changes materially, the entity type changes, or a policy's premium or death benefit no longer matches the price in the agreement. Many agreements we review were signed years ago and funded for a business that was worth a fraction of what it is today.

How Focused Financial Group helps

We review existing agreements and their funding, prepare an informal business valuation as a planning estimate, and coordinate with your attorney, who drafts the agreement, and your CPA, who advises on the tax treatment. We do not provide legal or tax advice.

Talk with us

Call 770-250-7588 or use the Contact Us page. Bring a copy of your current agreement and any policies that fund it.

This material is for general information only and is not legal or tax advice. Life and disability insurance products are subject to underwriting and have costs and limitations. Guarantees are based on the claims-paying ability of the issuing insurance company.