Why business owners need a buy-sell agreement
When an owner dies, becomes disabled, retires, or wants to leave, ownership stakes can become sources of conflict, liquidity problems, or operational risk. A buy-sell agreement (sometimes called a buyout agreement or ‘business will’) creates a pre-agreed roadmap for those events. In my practice advising closely held companies for 15+ years, I’ve seen well-drafted agreements prevent family fights, preserve customer and lender confidence, and protect business value.
(For general background on business succession planning, see FinHelp’s guide: Business Succession Planning: Transitioning Ownership Smoothly.)
Core components of a buy-sell agreement
A practical buy-sell agreement includes five core parts. Each should be drafted with legal and tax counsel.
- Trigger events (when the buyout applies)
- Common triggers: death, permanent disability, retirement, divorce, bankruptcy, termination for cause, or voluntary sale to a third party.
- Specify what constitutes a trigger (medical certification for disability, court rulings for bankruptcy, etc.).
- Who buys and who sells
- Cross-purchase: remaining owners buy the departing owner’s interest.
- Entity purchase (redemption): the company itself buys the interest.
- Hybrid: combination or default to one method if others aren’t feasible.
- Valuation method
- Fixed price: a set value reviewed periodically.
- Formula: based on revenue, EBITDA, or book value.
- Appraisal: independent valuation at time of trigger.
- Practical tip: include a tiebreaker appraisal process to avoid stalemates.
- Funding strategy
- Life insurance (cross-purchase or entity-owned) to provide immediate liquidity at death.
- Disability insurance or buy-sell disability riders for living owners.
- Company reserves or a sinking fund.
- Installment payments with security (e.g., a lien on shares).
- Transfer mechanics and restrictions
- Right of first refusal, transfer approvals, restrictions on transfers to third parties, and voting/management changes during the buyout process.
Funding strategies — pros, cons, and tax considerations
Life insurance is the single most common funding tool because it creates liquidity quickly. But structure matters:
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Cross-purchase insurance: each owner owns policies on the others. When an owner dies, the surviving owners receive proceeds personally and use them to buy shares. Advantage: potentially favorable tax basis adjustments for purchasers. Disadvantage: administratively complex when many owners.
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Entity-purchase (business redemption): the company owns policies on each owner and buys shares with proceeds. Advantage: administratively simpler; disadvantage: the deceased owner’s estate may still be included in estate tax calculations depending on ownership and incident of ownership rules.
Tax note: Life insurance proceeds are generally received income-tax-free by the beneficiary, but other tax and estate consequences can apply; always confirm with a tax advisor and review IRS guidance (IRS: https://www.irs.gov) and consumer resources (CFPB: https://www.consumerfinance.gov).
Other funding options include disability insurance to cover buyouts for permanent disability and a company-maintained sinking fund used to buy out departing owners over time. Installment buyouts can be useful but should include security and covenants to reduce risk of default.
Typical valuation approaches — and when to use each
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Fixed-price (periodically updated): simple and predictable. Best for small firms with stable earnings. Risk: price may become outdated when the market changes.
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Formula-based (e.g., multiple of EBITDA or revenue less liabilities): good for firms with measurable financials and agreed-upon metrics. Requires clarity on definitions (which expenses are added back, how to treat owner compensation, etc.).
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Independent appraisal on trigger: most defensible in disputes and when business value fluctuates. Higher cost and takes time, so the agreement should provide interim funding rules.
Practical rule: combine a formula with a mandatory independent appraisal if the parties disagree by more than a set percentage.
Real-world examples (anonymized from practice)
1) Smooth transfer after disability: A two-owner manufacturing business used a disability-triggered buy-sell with company-owned disability insurance. When an owner became permanently disabled, the policy funded a prompt purchase; the active owner retained control, and suppliers weren’t disrupted.
2) Conflict without a plan: A family-run retail company had no buy-sell. After an owner died, the surviving partners negotiated directly with heirs who lacked business experience. The result was a protracted dispute, loss of key employees, and revenue decline. That outcome is avoidable with clear preplanning.
Common pitfalls and how to avoid them
- Leaving valuation vague. Fix with a clear formula plus appraisal fallback.
- Forgetting to fund the buy-sell. Match your funding method to the trigger (life insurance for death, disability insurance for disability).
- Not updating the agreement. Major events (new owners, significant changes in revenue or capital structure) should trigger a review—aim for a review every 2–5 years.
- Ignoring tax and estate consequences. Coordinate with a CPA and estate attorney.
A practical checklist to draft or review your buy-sell agreement
- Identify triggers and define them precisely.
- Choose buyer structure (cross-purchase, entity purchase, or hybrid).
- Select valuation method and dispute-resolution mechanism.
- Decide on funding (who owns life policies, disability cover, sinking funds).
- Add transfer restrictions (right of first refusal, approval thresholds).
- Set a timeline for payment and include security if installment payments are permitted.
- Include procedures for valuation updates and periodic agreement review.
- Coordinate with legal, tax, and insurance advisors and document policy ownership and beneficiaries.
(For detail on valuation and buyouts in closely held companies, consider FinHelp’s resource: Structuring Succession for Closely Held Businesses: Valuation and Buyouts.)
Sample clause language (illustrative only)
“Upon the death of an owner (Trigger Event), the Company shall redeem the decedent’s shares at the price determined by the agreed formula. If the parties cannot agree on the price, an independent appraiser selected under Section X will determine fair market value. The purchase shall be funded by proceeds of Company-owned life insurance or, if unavailable, by equal installment payments secured by a pledge of redeemed shares.”
Note: This sample is for illustration and should not replace attorney-drafted language tailored to your state law and business structure.
Frequently asked practical questions
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Who needs a buy-sell agreement? Closely held businesses, partnerships, family companies, and any multi-owner firm that wants predictable succession.
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Can a buy-sell be enforced? Yes, if it is properly drafted and signed. State contract and corporate laws govern enforceability—work with counsel familiar with your state.
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Does a buy-sell avoid estate taxes? No—buy-sells manage ownership transfer and liquidity but do not eliminate estate tax. Proper estate planning and ownership of insurance policies can influence tax outcomes; consult your CPA and estate attorney.
Next steps if you don’t have a buy-sell agreement
- Gather your company documents (operating agreement, bylaws, capitalization table).
- Meet with your attorney and CPA to outline goals and constraints.
- Choose trigger events, valuation approach, and funding methods.
- Purchase and document insurance or set up funding mechanisms.
- Sign the agreement, record it where appropriate, and schedule periodic reviews.
(For a broader succession playbook, see FinHelp’s Succession Playbook for Family Businesses: Roles, Valuation, and Timing.)
Final professional notes and disclaimer
A robust buy-sell agreement combines clear legal language, a defensible valuation method, and realistic funding. In my experience advising hundreds of owners, the single biggest mistakes are treating the agreement as paperwork rather than a living plan and failing to update funding arrangements as the business grows.
This article is educational and not legal or tax advice. Always consult a qualified attorney, tax professional, and insurance advisor to draft and fund a buy-sell agreement tailored to your business and state law. Authoritative resources include the Internal Revenue Service and the Consumer Financial Protection Bureau (see https://www.irs.gov and https://www.consumerfinance.gov for general guidance).
