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How a buy-sell agreement can protect investors in a small business

On Behalf of | Jan 11, 2023 | Business Law

When two or more individuals decide to join forces in a small business, their heads are usually filled with visions of success and wealth. Rarely do people forming a small business think about events that might derail their hopes for the future.

Occurrences such as the divorce of one member of the entity, the unexpected illness or death of a member, or any other event that might cause members of the entity to decide that another member should be compelled to sell his or her interest to the remaining members.

A common tool to avoid these hazards is a buy-sell agreement. This post will focus on the necessary terms of an effective buy-sell agreement.

Basic elements

All effective buy-sell agreements have several elements in common. The most important element is the so-called “trigger clause.” Trigger clauses enumerate or describe the events that make the agreement active.

Examples of trigger events include the death or disability of a member of the enterprise, the divorce of a member, the personal bankruptcy of a member, or an irresolvable dispute between the member and the other members of the enterprise.

The trigger clause should describe all triggering events in unambiguous detail so that all members of the enterprise will understand when the terms of the agreement become effective.

Valuation clause

The buy-sell agreement must specify either the price to be paid to the departing member of the enterprise or a method of determining the price as close in time to the effectuation of the agreement as possible. Perhaps the most common method of determining the price of the departing member’s interest is retaining a professional appraiser to provide a realistic estimate of the interests of each member of the business.

Some buy-sell agreements employ the business’s chief financial officer or its accounting firm to make the valuation. Depending upon how the business has operated, this choice has the possibility of creating a conflict of interest for the chief financial officer or accounting firm.

Payment mechanics

Paying for the departing member’s interest can pose a difficult problem. One obvious solution is specifying that the price can be paid in instalments over time. Some corporations use term life-insurance on the lives of the members to provide funds for the buy-out in the event of a member’s death, but this method is not often useful in other situations that may prompt a mandatory purchase and sale, such as a divorce, bankruptcy, or disability.

A buy-sell agreement can be a complex document and should be reviewed by at least one experienced business attorney before it is signed by the parties.

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