There are a number of situations that may result in a partner exiting a business – some voluntarily, like retirement or moving on to something else, and others involuntarily, such as termination, legal issues, relationship issues, divorce, disability, or death. Generally, a voluntary exit is planned for in advance, but we frequently find that involuntary exits are NOT planned for. These situations may be extremely stressful and have an unfortunate conclusion if the right amount of planning isn’t done at the outset.
A buy-sell agreement should be put in place at the outset of the business whenever there are multiple partners or shareholders involved. This important legal agreement, if written properly, will establish clear expectations and help mitigate emotional, legal, and financial issues down the road when a partnership breakup is in the making. It is basically a blueprint for:
- Determining the value of a business
- Structuring the financial terms of the buy-out
- Outlining who will be in charge
- Transferring the ownership
These agreements should call for an initial business valuation so that all of the partners understand the valuation process (this can be enlightening!) and be able to more clearly envision how buy-out amounts would be calculated in the event of a separation. We use the word “amounts” because it is likely that there will be different formulas to address each of the causes for partnership dissolution, i.e., the amount may be higher in the event of death versus voluntarily leaving the company. There are also important tax considerations that should be taken into account when the buy-out formulas are developed.
The agreement should be reviewed annually, as part of the company’s year-end processes to ensure its relevancy. In addition, it is likely that key person life insurance will be needed to fund the buy-out in the event of a partner’s death, and this policy should be part of the annual review. Far too frequently, we have seen situations where partners sign buy-sell agreements, but never fund the buy-out with insurance, which can be financially disastrous for the remaining partner(s) and the company.
Buying out your partners is not easy but proper planning will save a lot of headaches and heartaches! No matter what exit option you are considering, always speak with trusted advisors to make sure you have the right plan in place before you move forward.