Buy-Sell Agreements: What are they, and why are they important?

When you decided to create a business, there was an entrepreneurial spark that occurred where you wanted to create something.  A thing that under the right circumstances, with enough effort and toil, blood sweat and tears, would become bigger than yourself.  To outlive you.  A way to achieve the elusive desire mankind has to be immortal in some fashion, because this creation would outlast you, and be here long after you are gone.

This is part of the essence which God put into us as humans, which differentiates us from all other parts of creation.  No other creature has this innate desire to create something that will leave an indelible mark on the world that says “I was here.  I made a difference”  This is the spirit of entrepreneurship.  As humans, we are different, because we have this desire – this need to make something that changes how the world works.  That changes how things are done.  Which changes how people live, interact, behave, respond, or function.

As an entrepreneur, you have at some point made the conscious decision to create a business built around some mission or philosophy.  To do something that needed to be done; to accomplish something that needed accomplishing.  And when you made that decision, you did NOT have the thought that it should also be a disposable business, right?  Of course not.  No one goes into a venture with the intent of it being thrown away, especially if it is a mirror of a person’s identity, ego, psyche, or self-worth.  So with that in mind, why would you build a business without having a safety net that ensures that your business continues to run, even if something takes you away from the helm, so to speak?

A proper order of operations when creating a business should include a few elements, regardless of the type of business that you are intending on starting up:

  • Business Plan

    • Work with an attorney specializing in business law and business formation.  Together you will draft these documents which will be needed for many other areas of your business life, so just do this, and don’t try to skimp on this step and go it on your own, because if you ever run into trouble later, you will regret not doing it up front.  Part of this process will have a section in it which relates to your business continuation, or as it is also called, “Buy-Sell Agreement“.  This agreement will spell out exactly what is going to happen with and to the business in the event that you (if sole proprietor) are not able to perform your duties either by being to sick or injured, or that you die by one manner or another.  I can not emphasize just how important this section is, because there are so many things that can happen in life, which we do not expect, that will derail our plans and change course for our business.  Don’t be a fool and skip this consideration and it’s related steps, because it can and will be the death-blow to your business.
    • Work with a Financial Planning Advisor that specializes in business planning, because even though you have approached the subject of your succession plans and the buy-sell agreement, you must also ensure that the business has taken action to fund its execution.  What I mean by that is simply this:  are you going to have so much money sitting around somewhere to be able to buy out your interest in your own business, or are you going to fund this transaction in another way?  Many business owners take care of the legal documents needed for the business plan including the buy-sell agreement, but never address the issue of funding the execution of the agreement.  What ends up happening is one of several possible scenarios up front, and then the outcome only continues to deteriorate from there.  With a sole proprietor, either the spouse or a child is forced to take over the responsibilities of managing and running the company, regardless of whatever their pre-existing responsibilities were and are.  This in turn will spin-off several other side-effects which may include does the spouse or child want to run the business, can they run the business as well – and if not what happens?  If the business has partners, then this is only amplified and magnified exponentially by the fact that the other parties involved may or may not want to, be able to, or be willing to work with the spouse or child – even if they were capable of doing a satisfactory job.
      • Then you have the cases of where the business does in fact have partners, board members, key indispensable employees, etc., which would need to be addressed in the event that the unforeseen event occurred to one of those individuals, as opposed to the founder / owner of the business.  Whom would absorb the responsibility of those duties, and what would that entail financially to the business – or would another person be required to fill the position either temporarily or permanently, and what would the financial repercussions be if that were what was to occur?
  • Business Valuation

    • This is also a key step with every business because you must first know what the company in worth, in order to determine whether what you have in place from the previously mentioned steps have been properly addressed and are still appropriate.  There are many different factors that go into the valuation of a company, but in short, these are the things that are relevant to our discussion here:
      • How much is the business worth, so that either a buy out or exit strategy may be executed, and where are the funds going to come from?  If the owner of the business is unable to run the company, but still living, then the financial responsibility of the company is actually two-fold.  Paying the salary of the owner so that they may be either cared for or rehabilitated, since their need for income has not gone away; and paying the salary of the person that takes over the role which the owner was performing.
      • This, likewise, if involving partners, board members, and key employees, must be established, because that mandatory position has its own attainable value to the business, and in turn, to fill its slot, will have expenses necessary.
        • Where partners and board members are concerned, the strategy most often used, is going to be what is called a cross-purchase strategy.  What this essentially means is that each individual has an interest in the well-being each of the other members.  The business entity must preserve this interest in ensuring that if any one of those top level people are unable to be present in their position, for any reason, then the business is able to buy out that person’s interest in the business, and in turn, replace the person whom is no longer able to perform their duties, either due to sickness, injury, or death.
        • When referring to the key employees, this is often referred to as a key-man (or key person) strategy, as certain positions within a business are going to by their very nature, be indispensable, and as such, requires special attention and due diligence.  In addition to this consideration being made, it will be necessary to establish employee classifications, since not every employee is going to be afforded the same value to the company, and in turn, require the same measures to be followed.
      • While time will pass with the business, it should be also increasing in value.  As such, it is also highly recommended that this entire process be reviewed at least every 5 years to determine where the company is at, what changes may have occurred, and what adjustments need to be made in the overall protection strategies that have been put into place, including the Buy-Sell strategies.  When changes in valuation occur, the specific needs for each person addressed in the agreement must also be looked at, and if necessary, adjustment being made to protect the business interest in each of those individuals, whether it be the owner, partners, board members, key employees, etc.  Failure to perform this routine maintenance step will result in under funding the execution of those agreements, and if the funds are unable to be located within the budget or accounts, then it is possible that liquidation of part or all of the company would eventually become necessary to satisfy all of the interests involved.

 

I acknowledge that this is a high-level overview of some of the moving parts present in the formation of a company and it’s business plan and associated buy-sell agreement section, but this is a far too often overlooked area of planning strategy.  As such, businesses which do not address the pitfalls covered in this article, as well as the others I run across in my practice, are forced to do the unthinkable.  To end the very legacy which they so longed to create for their family and its descendants.

You have one good shot at creating the vision that you dreamt of, so why take it to chance that you will not fall victim to what is inevitable to happen, and lose everything that you hope to build, just because you think it isn’t necessary?  After all, if you heard it from someone else that you didn’t need to do it, then chances are, they were not affected by this possibility, and thusly, not well enough informed with the realities of what will happen.

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