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Creating Effective Buy-Sell Agreements

Buy-Sell agreements allow businesses to limit the risks associated with an owner exiting the business, either through sale of their share or through their untimely death. Buy-Sell agreements prevent owners from passing their ownership interests to outside individuals that the original owners did not intend to be in business with, like a third party purchaser or the estate of a deceased partner.

Types of Buy-Sell Agreements

There are two main types of Buy-Sell agreements; cross-purchase agreements and entity-purchase agreements. In a cross-purchase agreement, the owner that is exiting the business agrees to sell his interest to the remaining business owners. This type of agreement is ideal for businesses that are smaller in size that have relatively few owners. The other type, entity-purchase agreements is more suited to larger businesses with many owners. In this type of agreement, the withdrawing owner sells his ownership stake back to the entity itself. The ownership interest is then indirectly re-spread to the remaining owners.

Structure of Buy-Sell Agreements

Buy-Sell agreements derive the most value when they are flexible and properly meet the needs of the particular business. To be effective these types of agreements should not only say how the interest will be sold but also explicitly the method by which ownership interests will be valued. This allows business owners to come to an agreement early on in their business relationship to avoid costly legal battles later.

There are several methods for determining the value of a business interest. These include fair market value, book value, and a formula approach. Each of these methods has its advantages and disadvantages. The particular situation of the business will dictate which of these methods should be used in the business’ Buy-Sell Agreement. Sometimes it is advantageous to utilize multiple valuation methods over different periods of the business’ lifetime.

Fair market value is determined by including a calculation of the business’ goodwill as well as an adjustment to the business’ assets to reflect their actual value if sold at the time of the execution of the Buy-Sell agreement. This type of valuation gives the owner that is selling his share a more equitable calculation of his interest. However, this method of valuation often requires outside appraisal and can be time-consuming. It is possible to structure the Buy-Sell agreement to allow for a mutual agreement between the owners on the fair market value of the business and thus avoid some of the problems associated with making a fair market value calculation.

A book value valuation can be particularly advantageous for newer businesses. This is because it is easier to calculate because it is determined by simply taking the appropriate percentage of the stated assets of the businesses currently on the business’ balance sheet. The disadvantage, however, is that this can be unfair to the withdrawing owner because assets on a company’s balance sheet are often lower than their fair market value.

Formulas may also be used to avoid the inherent unfairness of a book value evaluation and the costs associated with a fair market value calculation. This is done through some sort of approximation by formula. An example would be the share’s book value plus an arbitrary percentage (Example: Book Value + 10%).

Help with Buy-Sell Agreements

It is important to consult with your local Burlington County business attorney when creating Buy-Sell agreements. These agreements can help protect you from unwillingly going into business with third parties. Consulting with your attorney will also help you to identify the proper structure for your Buy-Sell agreement based on the particular needs of your business.