Small businesses depend on the people who created them. If they have a single owner, there's usually a period of time at the beginning of a company's history where the business would fail without him or her. Until a business is mature enough to have additional employees with a strong vested interest in the company's success, and strong relationships with the customers and community the business serves, it's very difficult for someone else to take over and keep things going.
On the other hand, many businesses are formed by groups of two or more like-minded people. Often, these business partners share a common vision but bring diverse sets of skills and experience to the enterprise, complementing each other's knowledge and abilities and helping to cover each other's weak points. Even as such a business matures, much of its success results from its partners' continuing ability to interact and plan together for the common good.
So when a business partner dies, a number of challenges arise for those left behind. Often, the surviving business partner will need to do the work of two people for a significant period of time to keep the business afloat. However, the surviving spouse and family of the deceased face their own obstacles, most notably the loss of a major source of income. Without proper planning, a spouse or child may be left without any way of getting cash in exchange for an interest in the business, while the surviving business partner may be left with new co-owners who know nothing about the business and may even have completely opposite interests. The result can range from a tense period of negotiations among the parties to outright conflict and expensive litigation. This strain can be the final blow to a business already stretched to the breaking point.
What a buy-sell agreement does
A buy-sell agreement lists exactly what will happen if a business partner is somehow unable to continue in the business. Although death is the most common contingency that business partners consider, other major life-changing events, such as a permanent disability or a divorce, can also invoke buy-sell agreements.
In general, a buy-sell agreement usually gives the surviving business partner a legal right to purchase the former partner's ownership interest in the business from his or her family. Once the surviving partner has complete ownership of the business, it is easier for the surviving partner either to move forward as sole owner or to try to get new business partners involved. The agreement is usually designed to prevent the family of the former partner from interfering in the operation of the business in ways that would be detrimental to everyone.
At the same time, the buy-sell agreement also serves the best interests of the surviving business partner's family. It provides much-needed money in exchange for an ownership interest in a business that generally cannot be readily converted to cash. Because most businesses do not have sufficient cash reserves to allow the surviving partner to buy out the former partner's ownership interest, the agreement sometimes gives the surviving partner the right to make payments on an installment basis, over a longer period of time. Alternatively, the partners can agree to buy life insurance policies for both partners, so that if one of the partners dies, the policy proceeds will provide the cash to buy out his or her interest.
Other potential benefits
In addition to giving the business the best chance to survive, a well-drafted buy-sell agreement can also play a role in the partners' estate plans. Buy-sell agreements typically include provisions for determining how much the business is worth, so that the surviving partner pays fair value for the former partner's ownership interest. Because it legally binds all parties to whatever amount of compensation its provisions determine, one can argue that the agreement determines the appropriate value to use in estate tax calculations. This can save the expense of having to obtain a formal valuation analysis of the business, and in some cases, it can reduce the amount of estate tax the former partner owns.
Caveats to consider
If you're a business owner with a partner, it's smart to think about a buy-sell agreement. However, you should keep a few things in mind. First, most buy-sell agreements are written in a symmetrical manner; the provisions are exactly the same regardless of who dies. But if your personal situations are completely different, terms that would work for your partner might not work for you. For instance, if your business partner has substantial assets outside the business, then your partner's family may not need as much money as soon after your partner's death as your family would need after your death. As a result, you must ensure that the provisions protect both you and your partner adequately.
Second, although life insurance often plays a key role in a buy-sell agreement, remember that insurance is just a tool to help the agreement work. Many insurance professionals focus only on the details of the insurance when dealing with business owners, rather than on the mechanics of the buy-sell agreement itself. The best insurance money can buy won't get the job done if the buy-sell agreement isn't drafted well.
Deciding to go into business with someone is as big a commitment as marriage. By being mindful of your business partner's personal commitments, you can both honor your partner in a time of need and ensure that your business will survive and flourish.
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Fool contributor Dan Caplinger welcomes your feedback. The Motley Fool has an ironclad disclosure policy.
