Why You Need a Buyout Agreement

If you're a co-owner, a buy-sell agreement is a must

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If you're a co-owner of a business, it's critical that you have a buyout agreement set up with your partner(s). A buyout agreement, also known as a buy-sell agreement, is a legal contract between the owners of a business that sets out how the future sale or buyout of an owner's interest in the business will be handled.

Typically a buyout agreement lays out when an owner can sell their interest in the business, who can buy an owner's interest (for example, whether the sale of the business is limited to other shareholders or will include third-party outsiders), and the valuation methods used to determine what price will be paid. A buyout agreement may also stipulate whether or not a departing partner has to be bought out and what specific events will trigger a buyout.

Buyout Valuation

Valuing an owner's interest in the business is normally the contentious part of any business buyout. The value of the business is normally determined by an examination of the company finances by an accounting professional who can assess the fair market value of the business. In an ideal situation, a partner or shareholder would maximize the selling price of their interest in the company by leaving at a time when the financial state of the business is optimal.

Other valuation factors include unpaid salary, dividends, or shareholder loans. There are also intangible effects on valuation—if the departing shareholder holds a vital position within the organization, this can have a detrimental effect on the continuity of the business. To avoid this, buyouts can be structured so that if a partner leaves they cannot open a competing business within a stated period of time or within the same geographical location, or cannot approach former clients.

Unfortunately, in many cases shareholders cannot come to an agreement regarding the valuation of shares and the buyout process comes to an impasse. This typically takes place when relations between shareholders have deteriorated and one or more shareholders wish to leave. The result is often lengthy and expensive legal action.

Shotgun to the Rescue?

To avoid this situation, some buyout agreements utilize the so-called "shotgun clause." This clause is triggered when one shareholder makes an offer to purchase the shares of the other partner(s) at a specific price. The other shareholder(s) must choose one of two options—they can either accept the offer or buy out the shares of the offering shareholder for the same price. This prevents either party from making a "low-ball" offer.

A Buyout Agreement Is a Must

Unfortunately, business partnerships (like marriages) have a high rate of failure—up to 80% depending on how the statistics are calculated. If you are entering a business partnership, you should set up a buyout agreement when you create your partnership agreement, either as part of the agreement itself or as a separate legal document.

There are many reasons a partner may want to exit a company, not all of them due to disagreements with other partners or difficulties in the business. For example, a partner may:

  • wish to leave the business to take a full-time job, start another enterprise, or retire
  • wish to sell out for financial reasons (such as personal bankruptcy)
  • become divorced or have other family issues
  • die or become incapacitated

The buyout agreement ensures that if any of these situations arise the other partners will be able to continue running the business. Without a buyout agreement, when one partner wants or has to leave, your partnership may be forced to dissolve or you could end up in court. A buy-sell arrangement is the best way to protect your business and your relationships with your partners.