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Why You Need a Buy-Sell Agreement
Most business partnerships start with the best intentions, but not every partnership ends that way. That's why buy-sell agreements are so important. A buy-sell agreement is a contract between business partners that dictates who can buy a departing partner’s share of the business and establishes a fair price for the partner's stake. The agreement also describes how to determine a company's value if all the owners decide to sell.
Partner Buyout
A typical buy-sell agreement covers a potential sale or buyback situation when a partner leaves a business. The agreement may specify to whom a departing partner can sell (usually they must sell to someone else in the business), and it also sets a fair price for their share of the business. This protects the remaining partners by guaranteeing that the departing partner will sell their share to a suitable owner, and it protects departing partners by assuring them a fair price for their shares of the business.
Business Buyout
It's not easy to determine a fair price in advance. A company's owners must agree on a price that, years from now, will represent their firm's true value. This is obviously a calculated risk: You cannot know today if your business will prosper in the years ahead or struggle to make a profit. Still, picking a fair price or a formula for setting the buyout price is essential. There are five common ways to determine a buyout price:
- Fixed price. The partners simply agree on a price for the business and put that number in the buy-sell agreement.
- Book value. The partners set a price based on the net value of the company’s assets minus its liabilities as shown on its most recent year-end balance sheet.
- Multiple of book value. If a small business has been up and running for several years, its real value is probably greater than its book value. The multiple-of-book-value method takes into account intangible assets that add to a company's worth such as patents, copyrights, brand names and trade names.
- Capitalization of earnings. This method measures a company's value based on its past profits. This works well for established companies with a solid financial history.
- Appraisal. A buy-sell agreement can stipulate that, at the time of a buyout, a professional business appraiser will establish the company's value.
No matter which buyout method you and your partners choose, it's important to have an agreement to avoid future disputes or lawsuits that may delay a transaction or affect the value of your business.
