Why buy-sell agreements matter
Family businesses combine financial value with personal relationships. A sudden ownership change — from death, divorce, disability, or a partner leaving — can trigger disputes, force distressed sales, or bring unwanted outside owners into the company. A properly drafted buy-sell agreement converts these disruptive events into an orderly transfer that preserves business value, cash flow, and family governance.
In my 15 years advising family-owned companies, I’ve seen buy-sell agreements prevent destructive litigation, protect customer relationships during transitions, and keep ownership within the family without sacrificing liquidity. Implemented well, they are the single most important contract for closely held firms.
(For practical government guidance on buy-sell arrangements see the U.S. Small Business Administration.) [https://www.sba.gov/]
Key types of buy-sell agreements and how each protects value
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Entity purchase (redemption): The business itself agrees to buy the departing owner’s interest. This can preserve continuity because remaining owners don’t have to come up with cash and no new outside owners are introduced. However, tax consequences and funding logistics differ from owner-to-owner purchases.
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Cross-purchase: Remaining owners purchase the departing owner’s interest directly. This often provides favorable tax basis adjustments for the buyers, which can lower future tax bills. It also makes sense for a small number of owners with the means to fund buyouts.
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Hybrid or wait-and-see: Combines features of both entity and cross-purchase plans, letting the enterprise or the owners decide at the triggering event which route to take.
Each structure protects value differently — choose based on ownership structure (number of owners, entity type such as S corp, C corp, or LLC), tax implications, funding capacity, and family dynamics.
Valuation: the single most contested element
A buy-sell agreement is only as good as its valuation method. Common approaches:
- Fixed price (rarely recommended unless regularly updated)
- Formula-based (e.g., multiple of EBITDA or book value plus adjustments)
- Appraisal clause (neutral third-party appraisal when triggered)
Best practice: include an agreed valuation method plus a fallback process (independent appraiser with time and fee rules) if parties disagree. Regularly update or test the formula to avoid stale valuations; many agreements include an annual or biennial valuation review.
Sources: family business research shows under-prepared valuations are a frequent cause of disputes (Family Business Institute; PwC family business surveys).
Funding the buyout: practical ways to avoid cash crises
Specifying how buyouts will be paid is crucial. Typical funding mechanisms:
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Life insurance: Owned either by the business (entity purchase) or by each co-owner (cross-purchase). Death benefits provide immediate cash to buy out the deceased owner’s heirs. Check policy ownership and beneficiary design to avoid estate tax complications. (See insurer and tax advisor guidance.)
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Installment payments: Agree on down payment, interest rate, and term. Include security (UCC filing, promissory note) and remedies for default.
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Company reserves or sinking fund: Regularly funded reserve kept by the business to cover expected buyouts.
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Third-party financing or seller financing: Lenders may be willing to finance a buyout if the company has predictable cash flow, but underwriting by a bank can complicate timing.
My practical tip: pair life insurance with an installment schedule. Insurance provides liquidity at death; installments reduce pressure on cash flow for retirements or voluntary exits.
Tax and legal considerations (high level)
Tax treatment varies by structure and transaction type. Important considerations:
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Cross-purchase vs. redemption: In a cross-purchase, the purchasing owners generally get a new tax basis equal to the purchase price they pay for the shares, which can provide a tax advantage on future gains. In an entity purchase, the corporation pays for the shares and tax consequences may differ; sellers may recognize gain, and remaining owners may not receive an increased basis in their shares.
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Estate taxes: For large estates, business interests subject to estate tax may trigger liquidity issues for heirs. Proper planning — including valuation discounts when appropriate, life insurance, and trusts — can mitigate estate tax risks. Always consult a tax advisor; see IRS guidance on business interests in estates.
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Insurance proceeds: Life insurance proceeds paid to a buy-sell plan can be treated differently depending on policy ownership and contract terms. Ownership structure determines whether proceeds are included in a decedent’s estate.
Because tax law changes and facts matter, work with a CPA or tax attorney when designing and funding a buy-sell agreement. (See IRS and Treasury guidance and consult your tax advisor.)
Drafting checklist — what to include
A thorough buy-sell agreement should cover:
- Triggering events (death, disability, retirement, bankruptcy, divorce, involuntary transfer, termination for cause)
- Type of agreement (entity, cross-purchase, hybrid)
- Valuation method and timing (formula, appraisal, periodic updates)
- Purchase price payment terms (lump sum, installments, interest rate)
- Funding method (life insurance specifics, company reserves, third-party financing)
- Restrictions on transfers and right of first refusal
- Noncompete and confidentiality clauses (tailored to reasonableness under state law)
- Dispute resolution (mediation/arbitration, choice of law, venue)
- Procedures for business governance and interim management when a triggering event occurs
- Periodic review schedule and amendment process
Common mistakes and how to avoid them
- Using a generic template: Off-the-shelf forms miss business-specific tax, governance, and funding issues.
- Failing to update valuations: A fixed price left unchanged for years can create unfair outcomes and litigation risk.
- Overlooking funding: A promise to buy without realistic funding turns a plan into an unenforceable paper contract.
- Ignoring family dynamics: Succession is emotional; the agreement should be discussed in family meetings with advisors to reduce surprises.
Examples from practice
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Manufacturing firm: A family manufacturing company used a cross-purchase plan funded with term life insurance and a five-year installment schedule for retirements. When a founder died, insurance proceeds paid heirs and the surviving family owners gained favorable tax basis on the purchased shares, allowing them to continue operations without interruption.
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Closely held restaurant: An entity-purchase funded by a sinking fund and supplemental insurance allowed the business to redeem shares while keeping management intact. This prevented an heir who lacked restaurant experience from becoming an active owner.
These examples illustrate two important points: (1) funding design must match the triggering event, and (2) operational governance must be coordinated with ownership changes.
Implementation timeline and practical steps
- Convene owners and advisors (attorney, CPA, insurance broker) to agree on objectives.
- Choose structure (cross-purchase, entity, hybrid) based on tax, funding, and governance analysis.
- Draft valuation and funding clauses with clear fallback rules.
- Obtain insurance quotes and set up policies consistent with the contract.
- Execute the agreement and fund initial payments or reserves.
- Review annually or with any major change (ownership change, tax law changes, significant business growth).
For more on structuring succession mechanics and valuation, see our Succession Playbook for Family Businesses, which covers roles and timing in greater depth: https://finhelp.io/glossary/succession-playbook-for-family-businesses-roles-valuation-and-timing/
If your business is closely held and needs detailed valuation and buyout mechanics, see “Structuring Succession for Closely Held Businesses: Valuation and Buyouts”: https://finhelp.io/glossary/structuring-succession-for-closely-held-businesses-valuation-and-buyouts/
Frequently asked questions
Q: How often should a buy-sell agreement be reviewed?
A: At minimum every 2–3 years, and immediately after major events (new owner, large growth, change of entity type). I recommend annual reviews in high-growth or tax-sensitive situations.
Q: Can heirs force the business to buy their inherited shares?
A: Only if the buy-sell agreement includes that triggering event (death) and provides a purchase mechanism. Without an agreement, heirs may inherit shares and become owners — often an undesirable outcome.
Q: Who should draft the agreement?
A: A lawyer experienced in business succession and tax implications; coordinate with your CPA and insurance broker.
Professional disclaimer
This article is educational and does not replace legal, tax, or financial advice tailored to your circumstances. Consult a qualified attorney, CPA, and insurance professional before finalizing a buy-sell agreement.
Authoritative sources and further reading
- U.S. Small Business Administration — resources on buy-sell agreements and ownership transitions: https://www.sba.gov/
- Family Business Institute — research on family business governance and succession planning: https://familybusinessinstitute.com/
- PwC Family Business Survey — insights on family business preparedness: https://www.pwc.com/
- Harvard Business Review — articles on succession planning and family firm governance.
Implementing a robust buy-sell agreement is both legal paperwork and family strategy. With clear valuation, realistic funding, and regular review, you can protect the business’s value, reduce conflict, and keep the enterprise running for the next generation.
