Why a Buy-Sell Agreement is a Necessity for a Small Business?

Today we’re going to talk about why having a buy sell agreement in place is crucial if you are a small business owner. Matt, will you tell us what a buy sell agreement is? Yeah, absolutely. So a buy sell agreement is an agreement.

Let’s just say, for example, that Jameson and I have a business and we’re 50 50 partners. And let’s further say that we’re both married, so God forbid I become disabled or I die if we don’t have this agreement in place.

Naturally, in most states, my spouse would then take over or have 50% rights to that business or the financial incentive. But if my spouse wasn’t involved or had no idea what the inner workings of the businesses, Jamison may not want to be in business with that spouse.

Then there’s going to potentially be disagreements, misalignments. Potentially there’s a misunderstanding of how the cash flow or the finances work. Maybe the funding isn’t there to buy that spouse out right away.

Maybe we’re in the middle of a recession. Having a buy sell arrangement just is a pre-stated agreement that if, God forbid, one partner passes or becomes incapacitated, that this other partner has the right to buy that person or that person’s beneficiary out, either at appraised value at the time or at a predetermined agreement.

There’s several types of buy sell agreements. Most of the time we recommend to have a life insurance program in place, a disability insurance program in place to fund these, because most businesses that operate on certain profit margins can’t suddenly afford to just come up with half of the value of the business on the spot.

So having an insurance program would look like this if our business was worth $2 million and I had the rights to 50% of that, Jameson had the rights to 50%. We’d each have a million dollar of equity in the business.

And if the business owned an insurance policy on each of us for a million dollars, that would be referred to as an entity buy sell agreement. If I pass. The business is the beneficiary of that million dollar policy.

My spouse hypothetically would then become 50% owner and then Jameson would have a pre written agreement to cut her the check for the million dollars to buy her out. So the ending result is the spouse would receive the million dollars and Jameson would not have any cash flow issues because the insurance would have paid the business.

And then he would then have 100% ownership of the business and be able to operate with autonomy and make sure that the needs of the business are uninterrupted, not just from disagreements that could arise, but also from cash flow perspective as well.

Now, depending on the type of business that you have and the tax implications, there’s another type that’s called a cross purchase agreement, which instead of the business owning the insurance policies, we individually own policies on each other.

The reasons for that. Would be certain tax considerations. We would recommend to consult with your advisor to consult with the CPA to see which arrangement is best for you if you’re a small business owner.

But we recommend, if not already in the operating agreement of your business, to have a written buy sell agreement in place and then discuss a funding mechanism, either through insurance or that could be an installment sale, where maybe it’s a ten year period which Jameson could buy out.

The Beneficiary who had come in the business over a ten year period, for example. Any questions on this, we look forward to answering.