The owners of most small, closely-held businesses negotiate and sign some form of an “Owner’s Agreement.” An important part of such Agreements is the “Buy-Sell” provisions. These are often some of the most difficult to negotiate. The gist of the buy-sell part of the Owners’ Agreement is to establish the rules for what happens if one of the owners exits the business because of
- Death
- Disability
- Retirement
- Divorce or
- Personal bankruptcy
Because the business is closely-held, the owners who remain with the business do not want to have an unpleasant surprise when an owner sells his or her ownership shares to a third-party stranger, or when, because of divorce or death, an ex-spouse or widow/widower is sitting in the boardroom, or when a trustee/creditors’ representative show up after being appointed during a personal bankruptcy, etc.
The buy-sell provisions attempt to solve these problems in advance and generally cover who can buy the ownership interests, under what condition and — importantly — at what cost. If the owners cannot agree at first on the price, then, usually a formula is agreed to or a mechanism for allowing the issue to be decided by business valuation professionals. The general idea is to ensure that the business can continue to operate smoothly while giving the owner who is exiting a fair value for their ownership interests.
Liquidity is, however, a problem that must be solved. As an example, a buy-sell provision might ban the sale of ownership interests to any third-party that is not “acceptable” to the other owners, providing that, after some amount of time or some number of candidates proffered, the other owners would be forced to buy out the ownership interests in question. In that situation, liquidity becomes a potential issue. Suppose the agreed buyout formula required payment by the company of $500,000. The company might be hard-pressed to come up with the payment amount.
This, then, is the purpose of buy-sell insurance. It is also often called “Business Continuity Insurance.” Generally, the insurance product is a combination of disability and life insurance and is not one policy, but several. The greater the number of owners, the greater the number of individual policies needed.
Buy-sell insurance can be structured to cover the first three problems addressed by the buy-sell provisions: death, disability and retirement. But, generally, buy-sell insurance will not cover problems potentially created by divorce or a personal bankruptcy. (As for those, extended payment plans or deferred sales are possible solutions along with strict separation of voting rights and dividend/profit rights).
In any event, typically, the buy-sell insurance is purchased, paid for, and owned by the company. This is because the purpose would be defeated if an individual owner let personal policies lapse by failing to pay the premiums. However, the specific arrangement depends on how the buy-sell is structured and there are tax consequences to be considered and evaluated by competent tax professionals.
Structuring Buy-Sell Agreements and Insurance: Key Legal Considerations
Buy-sell provisions are among the most consequential — and most frequently neglected — provisions in any closely-held business’s governing documents. The combination of a well-drafted buy-sell agreement and adequate buy-sell insurance transforms what could be a business crisis into a predictable and manageable transition.
The Two Primary Structures: Cross-Purchase and Redemption
Buy-sell agreements are generally structured in one of two ways, and the choice between them has significant legal and tax implications:
- Cross-purchase agreement. Under a cross-purchase structure, the remaining owners — not the company — are obligated to purchase the departing owner’s interest. Each remaining owner buys a proportionate share of the departing owner’s interest. In this structure, each owner would typically hold a life insurance policy on each other owner, using the proceeds to fund the purchase. For businesses with two or three owners, a cross-purchase structure is often straightforward. For businesses with more owners, the number of required policies multiplies quickly: four owners require twelve individual life insurance policies.
- Entity redemption agreement. Under a redemption structure, the company itself is obligated to buy back the departing owner’s interest. The company typically holds a single life insurance policy on each owner, using the proceeds to fund the redemption. This structure is administratively simpler for businesses with many owners, but it raises different tax considerations — particularly in C-corporations, where the corporate alternative minimum tax and accumulated earnings tax can affect the economics of holding large life insurance death benefits.
A hybrid approach — often called a “wait-and-see” buy-sell — gives the parties flexibility to determine at the time of the triggering event whether the company or the remaining owners will complete the purchase. Competent tax counsel should be involved in determining which structure is most advantageous given the company’s entity type (LLC, S-corp, C-corp, or partnership), the owners’ individual tax circumstances, and applicable state law.
Valuation: The Most Contested Element
The most common source of litigation arising from buy-sell agreements is disputes over valuation. An agreement that simply says the buyout price is “fair market value” is an invitation to conflict. Fair market value for a closely-held business interest is a complex determination that depends on the industry, the company’s financial performance, discounts for lack of marketability and lack of control, and the purpose of the valuation.
Well-drafted buy-sell agreements address valuation through one of the following mechanisms, or a combination:
- Fixed price. The owners agree in advance on a price per ownership unit, updated periodically (typically annually) by unanimous agreement. Simple but often falls out of date.
- Formula-based valuation. A predetermined formula — such as a multiple of trailing EBITDA, or book value adjusted for specified items — is applied at the time of the triggering event. More objective, but the formula must be reviewed and updated as industry conditions change.
- Appraisal mechanism. Each side selects a certified business valuator; if the two appraisals are within a specified range, the price is their average; if not, the two appraisers select a neutral third appraiser. This process is accurate but expensive and slow.
Disability Insurance: The Overlooked Component
Life insurance funding for buy-sell agreements is well understood, but disability is statistically a more likely triggering event for most business owners under 65. Disability buy-out insurance (also called business overhead expense disability insurance) provides a lump sum or periodic payments to fund the buyout of a disabled owner’s interest. The definition of “disability” in the policy must align precisely with the definition in the buy-sell agreement. Policies commonly use an “own occupation” vs. “any occupation” standard, and the elimination period — the waiting period before benefits begin — must be defined and reflected in the buy-sell agreement’s timeline for triggering the buyout obligation.
Integrating with the Operating Agreement or Shareholders’ Agreement
Buy-sell provisions are most effective when they are fully integrated into the company’s governing document — the operating agreement for an LLC or the shareholders’ agreement for a corporation. Standalone buy-sell agreements that are inconsistent with the operating agreement create ambiguity and litigation risk. Annual reviews of both the governing documents and the insurance policies are essential to ensure that coverage amounts keep pace with the company’s current valuation.
Do not leave your business’s future to chance. Contact the Business attorneys at Revision Legal or visit our business law practice page to discuss drafting or updating your buy-sell agreement.
Contact the Business Attorneys at Revision Legal
For more information, contact the experienced Business Lawyers at Revision Legal. You can contact us through the form on this page or call (855) 473-8474.
