REFLECTIONS ON THE TRADITIONAL BUY-SELL AGREEMENT ...

REFLECTIONS ON THE TRADITIONAL BUY-SELL AGREEMENT
Every small business having more than one owner needs a Buy-Sell Agreement! Sooner
or later most of us will retire; some of us will become disabled; and all will die. Unless we have
a well drawn Buy-Sell Agreement in place, we almost certainly will leave serious problems for
our families and our former business partners to deal with.
Most of us probably have a Will, a life insurance policy or two, and many of us will have
a disability policy. Armed with these important but standard documents, we tend to think we
have adequately prepared for almost any contingency. These documents alone, however, will
not help in any way to prevent turmoil “at the shop” caused by an unexpected death, retirement
or disability. The traditional Buy-Sell Agreement will almost always meet these needs if
properly drawn.
Buy-Sell Agreements apply equally to corporations, limited liability companies and
partnerships. For simplicity, I will refer to the company of concern, regardless of the type entity,
as the “company.” I will refer to the holders of the ownership interests (whether partners,
shareholders or members) as “owners.” Keep in mind that Buy-Sell Agreements are not limited
to the departure of an owner only because of retirement, disability or death. They can apply to a
departure or withdrawal of an owner for any cause whatever.
BASIC TYPES OF BUY-SELL AGREEMENTS:
Two basic types of Buy-Sell agreements are available:
One basic type is the Redemption Agreement, sometimes referred to as an Entity
Purchase Agreement. A Redemption Agreement is an agreement between the company and the
owners which obligates – or allows – the company to purchase the interest of an owner who dies,
becomes disabled or retires. Thus, when the triggering event occurs (death, disability or
retirement of an owner) the company would have a duty - or sometimes an option - to purchase
the “departing” owner’s interest in the company. The agreement of course, also creates a duty by
the owner, or his estate, to sell his interest to the company upon payment of the purchase price.
The purchase and sale would eliminate the turmoil almost certain to result if the surviving spouse
or children of the decedent suddenly became business partners. It would also preserve
management cohesion without serious interruption. 1
1 The comments and observations that follow have been derived and distilled largely from the writings of others.
Particularly helpful was the Planner’s Guide to Buy-Sell Agreements for the Closely Held Business published by
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All this sounds easy. It isn’t as easy as it sounds. Questions Abound! For example:
* How will the company pay for the departing owner’s share?
* how is the departing owner’s share to be valued?
* how will that share be distributed among the surviving owners?
* if the triggering event is disability rather than death or retirement, how is
“disability” to be defined?
* what are the tax consequences to the company, the seller and to the
surviving owners?
CROSS PURCHASE AGREEMENT
The other basic type agreement is the Cross Purchase Agreement. This is an agreement
between or among the owners which obligates – or allows – one or more of the other
owners to purchase the interests of another owner who has died, become disabled or
retired. The triggering events are the same as in the Redemption Agreement, and the
problems are essentially the same. However, instead of the company having a duty to
make the purchase, the surviving owners have the duty to make the purchase, and the
decedent’s estate has a duty to sell the decedent’s interests to the surviving owners in
accordance with the terms of the agreement.
Ordinarily, the company should be made a party even in a Cross Purchase Agreement so
as to allow the company, to also be a prospective purchaser of the departing owner’s
interests. If this is done, the result is a sort of hybrid agreement bearing some of the
characteristics of both basic type agreements.
Care should be taken in selecting the type of Buy-Sell agreement to implement. If the
company will likely be under severe financial stress by the loss of an owner, a Cross
Purchase Agreement would probably be better. But if more stress would seem to fall on
the surviving owners to produce the necessary cash for a purchase, then a Redemption
Agreement would probably be the better choice.

BENEFITS OF BUY-SELL AGREEMENTS
Now that the Buy-Sell Agreement has been defined or described, let’s set out some of the
main benefits of having such an agreement. The benefits that come to mind first are:
1. Control of Ownership: Such an agreement helps to control who can become an
owner of the company. If A is in business with B and B suddenly dies – and there
is no Buy-Sell Agreement - A will probably find himself in business with B’s wife
and/or children. They may know nothing about the operation of the business, but
they may prove to be difficult to work with even in routine management decisions.
On the other hand, B may go through a divorce and his wife may succeed in
wresting his ownership interests away from him in a court proceeding. The same
difficulties may result.
In either event, a properly drawn Buy-Sell Agreement could avoid these results.
2. Smooth transition of Ownership and Management: A Buy-Sell Agreement
allows a transition of ownership without confusion or dispute. When an owner
dies, is disabled or retires without a “game plan” for such transition, there often is
a scramble among the other owners to protect their own interests. This often leads
to suspicion, jealousy and fear among the surviving owners. Cohesion in
management is destroyed or damaged and the success of the business is
threatened. A well crafted Buy-Sell Agreement will give all the owners peace of
mind knowing an advance plan for the transition is in place.
3. Training for the Future: Such an agreement encourages the owners to begin at
an early time to cultivate and train the next generation of managers. It thus helps
to ensure a smooth transition from the present owners to the next generation of
owners. Without a Buy-Sell Agreement to lay the groundwork, attention to the
transition is often neglected.
4. Insurance Can Ease Pain of Cash Flow Requirements: When an owner
retires, becomes disabled or dies, the surviving owners will want to acquire his
interest – and usually the estate will want to sell it. Without an agreement, there
will be issues over just who it is that is entitled to purchase the decedent’s
interests, how to value the decedent’s interests and how to pay for it. The
question of entitlement to purchase and the question of valuation, of course, are
separate problems but the purchase of insurance can greatly reduce the stress of
raising funds to pay for a buy-out whether by means of a Redemption Agreement
or a Cross Purchase Agreement.

5. Establishes Valuation: A well drawn Buy-Sell Agreement will establish a
formula to value a departing member’s interest. This will avoid an almost certain
clash of self-interests when the triggering event occurs.
6. May Save Sub-S Classification: Sub-S corporations are limited to certain types
of authorized shareholders. There is a possibility, without a well crafted Buy-Sell
Agreement, that the interests of an owner might somehow end up in the hands of
an unauthorized entity. If that happens, the corporation will lose its Sub-S
classification with the IRS. An agreement can restrict ownership of the corporate
shares to authorized entities.
7. Non-Compete Considerations: In the event an owner simply decides to
withdraw, there is a danger that he may go into competition with the company and
take its best customers. A well crafted Buy-Sell Agreement can provide that, in
the event of a withdrawal, a departing owner is restricted in his ability to compete
and is forbidden to solicit company customers, employees, etc. Such agreements
are more easily accepted by all owners when a venture is fresh and everyone is
optimistic that the business will prosper.
8. Creation of Market to Sell Shares: Ownership interests in a closely held
company are usually not readily marketable. The execution of a Buy-Sell
Agreement creates a market to dispose of such interests. The consideration for the
creation of the market is the surrendering of a right to compete in the event of a
withdrawal, or perhaps the surrendering of some other potential right.
9. Capital Contributions: It isn’t unusual for a company to need more capital to
operate. It isn’t unusual, either, to find that some owners are better able than
others to furnish that additional capital. But when one owner furnishes more
capital and others don’t, his relative ownership interest grows and theirs is
diminished. A Buy-Sell Agreement can control such situations.
10. Disputes: Unfortunately, it is rather common for owners to get into disputes.
This is especially true when the business does not prosper. A Buy-Sell Agreement
can offer some relief by providing for arbitration or mediation of disputes, or by
providing what is known as a “Put-Call Option”. That is where owner A can offer
to buy B’s interests for a specified sum. B would then have a duty to either sell to
A at that price, or to purchase A’s interest for the same price.

FUNDING OF BUY-SELL AGREEMENTS
There are several ways to fund such agreements. The main ways are:
1. The company can establish a sinking fund for a Redemption Agreement. This
carries some risk that the company could be penalized by the “Accumulated
Earnings Penalty Tax”.
2. The company could borrow the money to redeem the stock.
3. The agreement could be funded by life insurance.
The funding of such agreements with life insurance (and, as the case may be, with
disability insurance) is the usual way. Who will be the owner or owners and beneficiaries
of the insurance policies, and who will pay the premiums?
In a Redemption Agreement, the company is ordinarily the owner and beneficiary of a
policy on each owner and premiums are usually paid by the company.
Upon the death of an owner, the insurance proceeds are paid to the company which then
uses those proceeds to pay the estate for a transfer of the decedent’s ownership shares.
In a Cross Purchase Agreement, each owner is ordinarily the owner and beneficiary of a
policy on the other owners and each owner ordinarily pays the premiums on the policies.
Upon the death of an owner, each of the surviving owners will receive insurance proceeds
on his or her respective policy and, with those proceeds, will purchase a portion (typically
a pro-rata share) of the decedent’s interests in the company.
It should be noted here that the decedent will have a policy of insurance on the lives of
the surviving owners. The surviving owners will usually want to recover these policies.
The Buy-Sell agreement should contain a provision that allows them to purchase the
policies. This policy is normally purchased at its cash surrender value.
THE TRIGGERING OF A BUY-SELL AGREEMENT
The trigger in the event of a death of an owner is the death itself. This is an easy and
unambiguous point in time.
The triggering event in case of a disability is not so easy. How do you define disability?
It could be defined in many ways. For the purposes of a Buy-Sell Agreement, probably it
should be defined basically as the inability of an owner to work for say 90 days. At such
point in time, the other owners would then have the right (or duty) to purchase that
person’s interests. Even here, though, disputes can arise over how to define “work”.

Another situation that often causes turmoil in a business is the discharge from
employment of one who is an owner. A Buy-Sell Agreement might require that one
cannot be an owner unless he is employed, or it might provide that being an owner does
not guarantee employment. To be discharged from employment would perhaps require
the sale of his interests. Issues can then arise as to whether the discharge was for just
cause. A properly drawn agreement could provide for most if not all these issues.
VALUATION OF AN OWNERSHIP INTEREST
The loss of a principal owner will almost always have a chilling effect on a closely held
company. There will be a diminished ability to generate income, loss of expertise and
loss of business contacts – and, at the same time, there will be additional costs associated
with finding and training a replacement. Such losses therefore throw the company’s
valuation into uncertainty. A Buy-Sell Agreement can provide a formula for arriving at a
valuation and thus avoid conflicting arguments over valuation. There are many
approaches to valuation. Some are:
* A simple appraisal by competent financial experts; or
* Book Value or some variation of it; or
* An annual valuation process using an acceptable formula.
CONCLUSION
A Buy-Sell Agreement is a bit like a pre-nuptial agreement. It is the type agreement that
you would prefer to never have to use, but it is critical if there is ever a need. An owner
who fails to properly plan for the contingencies mentioned above may find himself
working through a disaster that could have been avoided or at least minimized.
Charles E. (Ed) Isom
P.O. Box 2066
Anniston, Alabama 36202

REFLECTIONS ON THE TRADITIONAL BUY-SELL AGREEMENT
I. INTRODUCTION
II.
BASIC TYPES OF BUY-SELL AGREEMENTS
1. REDEMPTION AGREEMENT (OR ENTITY
PURCHASE AGREEMENT)
2. CROSS PURCHASE AGREEMENT
III.
BENEFITS OF BUY-SELL AGREEMENTS
1. Control of Ownership
2. Smooth Transition of Ownership and Management
3. Training for the Future
4. Insurance Can Ease Pain of Cash Flow Requirements
5. Establishes Valuation
6. May Save Sub-S Classification
7. Non-Compete Considerations
8. Creation of Market to Sell Shares
9. Capital Contributions
10. Disputes
IV.
FUNDING OF BUY-SELL AGREEMENTS
V. THE TRIGGERING OF A BUY-SELL AGREEMENT
VI.
VII.
VALUATION OF AN OWNERSHIP INTEREST
CONCLUSION
C. E. (Ed) Isom
Isom & Stanko, LLC
P.O. Box 2066
1021 Noble Street
The Noble Building (Suite 100)
Anniston, Alabama 36202
www.isomstanko.com
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