03 Aug What Is a Buy-Sell Agreement and Why Every Business Owner With a Partner Needs One
If you own a business with one or more partners and you do not have a buy-sell agreement in place, you are operating without one of the most important legal protections available to business owners.
A buy-sell agreement is a legally binding contract between co-owners of a business that determines what happens to an owner’s share of the company if they die, become disabled, retire, want to sell their interest, or experience a personal financial crisis like bankruptcy or divorce. Without one, any of those events can trigger a business dispute that is expensive, time-consuming, and potentially fatal to the company itself.
This guide explains what a buy-sell agreement is, why it matters more than most business owners realize, how the most common structures work, and what to do if you do not have one in place yet. If you want to understand what your business is worth before any of these conversations begin, start with the free ExitOnTop Business Valuation Calculator.
What Is a Buy-Sell Agreement and How Does It Work?
A buy-sell agreement, sometimes called a business succession agreement or a business will, establishes the rules for what happens to a co-owner’s interest in a business when a triggering event occurs. It defines who can buy the departing owner’s shares, at what price, and on what terms.
The agreement typically covers a defined list of triggering events. These almost always include death and permanent disability, which are the events most owners think about when they first consider a buy-sell agreement. But well-drafted agreements also cover voluntary departure, retirement, divorce where a business interest might transfer to a spouse, personal bankruptcy, loss of a professional license that is material to the business, and situations where an owner simply wants to exit the partnership on their own terms.
By establishing the rules in advance, a buy-sell agreement prevents the disputes that arise when partners have to figure out these situations in real time under emotional and financial pressure. It also protects each owner’s family by ensuring that a clear, fair process exists for converting a business interest into cash when it is needed most.
Why Do So Many Business Owners Operate Without a Buy-Sell Agreement?
Most business owners who lack a buy-sell agreement fall into one of two categories. Either they never thought about it when they formed the partnership and it has never come up since, or they thought about it, started the conversation with their attorney, got busy, and never finished the process.
A third reason is that partners sometimes avoid formalizing these arrangements because the conversation requires them to confront uncomfortable scenarios: what happens if one of us dies, what happens if one of us wants out, and how do we actually value the business if we ever need to. These are not comfortable discussions, especially between people who have built something together and prefer to focus on the future rather than contingency planning.
The problem is that the absence of an agreement does not make those scenarios less likely. It just means that when they happen, there is no framework for resolving them. And at that point, every decision gets made in the context of stress, grief, financial pressure, or legal dispute rather than the calm, aligned state in which a good agreement is written.
What Are the Most Common Types of Buy-Sell Agreement Structures?
There are three primary structures used in buy-sell agreements for small businesses, and choosing the right one depends on the number of partners, the size of the business, and the specific goals of the owners involved.
The first is a cross-purchase agreement. In this structure, the remaining owners agree to purchase the departing owner’s interest directly. Each owner buys a proportional share of the departing partner’s stake. Cross-purchase agreements are most practical for businesses with two to four owners and work well when the remaining owners have or can access the capital needed to fund the purchase.
The second is an entity purchase agreement, also called a stock redemption agreement. In this structure, the business itself purchases the departing owner’s interest rather than the remaining owners doing so individually. This is simpler to administer when there are many owners and can have tax advantages depending on the business entity structure.
The third is a hybrid or wait-and-see agreement, which gives the company the first option to purchase the departing owner’s interest and allows the remaining owners to purchase any interest the company declines to buy. This structure provides maximum flexibility and is popular in businesses where the optimal structure may depend on circumstances at the time of the triggering event.
How Is the Purchase Price Determined in a Buy-Sell Agreement?
The valuation mechanism in a buy-sell agreement is one of the most important and most frequently contentious provisions. Getting this right matters enormously because it determines how much a departing owner or their estate actually receives.
The three most common approaches are a fixed price, a formula, and an independent appraisal. A fixed price is the simplest: the owners agree on a specific dollar value for the business at the time the agreement is signed and update it periodically. The problem with fixed prices is that they require discipline to keep current, and many agreements become outdated because the partners never get around to updating the number as the business grows.
A formula-based valuation uses a predetermined calculation, such as a multiple of annual revenue or a multiple of earnings, to determine the price when a triggering event occurs. Formulas are objective and automatic but may not accurately reflect the actual market value of the business at the time of the event, particularly if industry conditions or the business’s specific circumstances have changed significantly.
An independent appraisal requires the parties to obtain one or more professional business valuations at the time of the triggering event. This approach produces the most accurate reflection of fair market value but can also lead to disputes if the parties obtain conflicting appraisals and cannot agree on a resolution process.
Understanding how professional business valuations work and what drives your company’s value is essential before finalizing the valuation mechanism in your buy-sell agreement. Our post on the three business valuation methods explains how professionals arrive at a value and what each method captures.
How Should a Buy-Sell Agreement Be Funded?
Having a buy-sell agreement in place is only half the solution. The other half is ensuring that the funds to execute the purchase are available when a triggering event occurs. The most common funding mechanism for buy-sell agreements is life insurance.
In a cross-purchase structure, each owner purchases a life insurance policy on each of the other owners. When one owner dies, the surviving owners receive the insurance proceeds and use them to purchase the deceased owner’s interest from their estate. This approach works cleanly for businesses with two owners but becomes administratively complex with more partners.
In an entity purchase structure, the business owns and is the beneficiary of a life insurance policy on each owner. When a triggering event occurs, the company uses the insurance proceeds to fund the purchase of the departing owner’s interest.
For triggering events other than death, such as disability or voluntary departure, funding mechanisms typically include installment payments over time, seller financing, or a combination of the owner’s personal capital and business cash flow. The buy-sell agreement should specify the payment terms for each triggering event so there is no ambiguity about how the purchase will be funded.
What Should You Do If You Do Not Have a Buy-Sell Agreement?
If you own a business with partners and do not have a buy-sell agreement, the most important first step is to have a direct conversation with your co-owners about putting one in place. The conversation does not need to be framed as planning for disaster. It can simply be framed as responsible business planning that protects everyone’s investment and ensures the business can survive any transition.
Once you have alignment with your partners, engage a business attorney who has experience with partnership agreements and business succession planning. The attorney will help you identify the triggering events that matter most for your specific situation, choose the right structure, establish an appropriate valuation mechanism, and put funding arrangements in place.
The time and cost of creating a well-drafted buy-sell agreement is a fraction of the cost of resolving a partnership dispute without one. And in the context of a planned exit, having a clear ownership structure and succession agreement in place makes the business significantly more attractive to buyers, who want to acquire a company with clean, documented ownership arrangements rather than one with potential disputes waiting to surface.
If you are planning an exit and want to understand how your ownership structure affects your valuation and your exit options, our guide on common exit planning mistakes covers several of the most frequent issues that arise when owners have not formalized their business structures.
Understand what your business is worth before any ownership transition: https://exitontop.com/business-valuation-calculator/
Disclaimer: This content is for general educational purposes only and should not be considered financial, legal, or tax advice. Every business and situation is unique. Please consult a qualified advisor before making any decisions.