Most business owners with partners have heard of a buy-sell agreement. Many even have one sitting in a filing cabinet somewhere, drafted years ago when the partnership was formed. But having an agreement and having a functional one are two very different things.
The gap between those two things is where problems live. And the problems tend to surface at the worst possible time: when a partner dies, becomes disabled, or decides to leave the business unexpectedly.
What a buy-sell agreement actually does
A buy-sell agreement is a legally binding contract that defines what happens to an owner's share of the business when a triggering event occurs. It answers the questions that nobody wants to think about: Who gets to buy the departing owner's shares? At what price? With what money? On what timeline?
Without these answers locked in ahead of time, you're left negotiating under duress, often with a grieving family, a disabled partner, or an owner who's already checked out mentally.
The funding problem
Here's where most agreements fall apart. A buy-sell might say that the remaining partners will purchase the departing owner's share at fair market value. That sounds reasonable on paper. But where does the cash come from?
If the business is worth $3 million and a partner owns a third, the remaining owners need to come up with roughly $1 million. Quickly. Most businesses don't have that sitting in a reserve account. And most owners can't personally write that check.
An unfunded buy-sell agreement is a promise without a plan to keep it.
The most common funding mechanism is life insurance. Each partner's share is backed by a policy that pays out when a triggering event occurs. The proceeds go toward purchasing the departing owner's interest, keeping the business intact and the transaction clean.
Two common structures
Buy-sell agreements generally follow one of two models:
- Cross-purchase: Each owner buys a policy on the other owners. When an owner exits, the remaining partners use the insurance proceeds to buy that person's share directly. This works well for businesses with two or three partners, but the number of policies required grows quickly with more owners.
- Entity redemption: The business itself owns policies on each partner. When a triggering event occurs, the company buys back the departing owner's shares. This is simpler to administer but can have different tax implications depending on the entity structure.
There are hybrid approaches too. The right structure depends on the number of owners, the entity type, and the tax situation. This is one of those areas where the details matter more than the concept.
The valuation question
Even when the agreement is funded, there's another common failure point: the valuation. Many buy-sell agreements set a fixed price at signing ("the business is worth $2 million") and never update it. Five years later, the business might be worth $5 million, but the agreement still says $2 million.
The departing owner's family gets shortchanged. Or the remaining partners overpay because the business has actually declined. Either way, an outdated valuation creates conflict.
The better approach is to include a valuation formula or require periodic independent appraisals. Some agreements call for an annual review of the agreed-upon value. Others tie the price to a multiple of revenue or earnings. The method matters less than the commitment to keeping the number current.
Trigger events to think through
Death is the most obvious trigger, but it's not the only one. A solid buy-sell should address:
- Death of a partner
- Total or partial disability
- Voluntary departure or retirement
- Divorce (to prevent an ex-spouse from becoming a business partner)
- Bankruptcy or creditor claims against an owner
- Involuntary termination or breach of the partnership agreement
Each trigger may call for different terms. A retirement might allow for a gradual buyout over several years, while a death needs immediate liquidity. The agreement should spell out the timeline and mechanics for each scenario.
The bottom line
A buy-sell agreement isn't a set-it-and-forget-it document. It needs current valuations, adequate funding, and language that accounts for real-world scenarios. If you have partners, this is one of the most important pieces of your business continuity plan.
If you have an agreement and haven't reviewed it recently, pull it out and read it. If anything looks outdated, or if you're not sure how it would actually play out in practice, it's worth a conversation.