What happens when a co-owner of a business dies? What happens when a co-owner wants to withdraw? These questions may be answered in advance if the co-owners enter into a buy sell agreement.
When one co-owner dies a buy sell agreement requires the surviving co-owners or the business itself (typically a corporation) to purchase the deceased co-owner’s interest in the business (typically the decedent’s corporate stock). This eliminates the possibility that a surviving spouse or other heir with no knowledge of the business will inherit the stock and disrupt the corporation’s operations.
Funding for the purchase is provided to the surviving co-owners or to the corporation by life insurance. In the first instance each co-owner buys life insurance on the others, naming himself or herself as the beneficiary. This is called a cross purchase agreement. In the second the corporation buys the insurance and names itself as the beneficiary. This is called an entity-purchase or redemption agreement. The two have entirely different tax consequences which the co-owners should understand before they choose one or the other.
The amount of life insurance maintained from time to time depends upon the anticipated purchase price of the insured’s stock. Therefore an important part of the agreement is the method specified for valuing the business (and thus the stock) at the time the insured dies. The simpler the method the more likely it is that the insurance proceeds will prove to be approximately equal to the actual purchase price.
When one co-owner wants to withdraw, a buy sell agreement also gives the other co-owners or the corporation a right of first refusal of any offer from a third party received by the withdrawing co-owner for his or her stock. Because life insurance proceeds are not being paid to the other co-owners and sufficient funds may not be otherwise available to them, the agreement does not require them to purchase the withdrawing co-owner’s stock at any price or at all.
On withdrawal of one co-owner, a buy sell agreement thus gives the other owners an opportunity to avoid continuing in business with a new and unwanted co-owner, while placing an obstacle in the way of a co-owner intent on withdrawing to cash out or avoid conflict with other co-owners. A put-call agreement might solve this problem, but it would be unusual in this context and it is not what lawyers and accountants mean by the term buy sell agreement. It would also be difficult or perhaps impossible to negotiate, as well as expensive.
Given the purposes and limitations of buy sell agreements their costs may outweigh their benefits for new small businesses with limited resources whose co-owners are young. For established small businesses with ample resources whose co-owners are older, buy sell agreements are almost always worthwhile.
San Diego Attorney Stanley D. Prowse is a business attorney that specializes in California buy sell agreements. We welcome your legal inquiries.