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What Is A Buy-Sell Agreement?

Written February 1, 2017

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A buy-sell agreement, also known as a buyout agreement, sets forth what will happen if one of the co-owners of a company leaves the company for any reason, including death. There are two main types of buy-sell agreements: the cross-purchase plan and the stock redemption plan. We generally recommend a stock redemption plan.

Every company with more than one owner needs a buy-sell agreement. These agreements set a strike price in advance for the departing shareholder’s stock, create a market for the business interest (which can be difficult with closely held corporations) and assure business continuity for the remaining active owners, employees, customers, and creditors.

The two main types of buy-sell agreements are the cross-purchase plan and the stock redemption plan.

Under a cross-purchase plan, each company shareholder agrees in advance to buy the shares of the withdrawing shareholder while the withdrawing shareholder agrees to sell his or her shares to the remaining shareholders. The corporation is not involved in the transaction.

Under a stock redemption plan, the corporation redeems the shares of the withdrawing stockholder.

Both types of plans cover:

  • the type of events that trigger a buyout,
  • persons that may purchase the departing shareholder’s stock,
  • the valuation of the departing shareholder’s stock, and
  • how the buyout will be funded.

Both cross-purchase and stock redemption plans are generally funded by life insurance policies. In a stock redemption plan, the corporation purchases one policy for each shareholder. In a cross-purchase, plan each shareholder buys a life insurance policy on the life of every other shareholder, pays the premiums out of their own pocket and is the policy’s beneficiary. For example, if a company had 7 shareholders, 42 life insurance policies would need to be purchased.

Due to the extra administrative burden of cross-purchase plans, the out of pocket cost for shareholders, and the potential for unequal insurance costs due to individual health and age, I generally recommend a stock redemption plan. But as always, this is general advice. Each company’s situation is going to be unique and there is no one-size-fits-all method. Factors such as the number of shareholders, their relative ages, available personal funds, company valuation, insurability, taxation and the events that mandate shareholder withdrawal must all be considered in crafting your company’s buy-sell agreement.

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