What Is a Buy-Sell Agreement & When You Might Need One

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At some point, every business with more than one owner faces the same question: What happens when an owner wants out? Whether it’s a result of retirement, disability, or even an owner’s death, ownership interests will change hands. Without a plan, these transitions can be tumultuous or even ruinous.

One solution is a buy-sell agreement. It answers this question upfront, establishing clear terms for how ownership will transfer, who can buy, and at what price. For business owners seeking continuity and financial stability, this agreement protects the mutual interests of departing and remaining owners when a triggering event occurs.

What is a buy-sell agreement?

A buy-sell agreement (also called a buyout agreement) is a legally binding contract that defines how and when owners of a closely held business can transfer their respective ownership interest. The primary purpose of a buy-sell agreement is to ensure the orderly transfer of ownership when a triggering event occurs in a privately owned business. This can happen because of death, disability, retirement, divorce, or an owner’s bankruptcy. The agreement dictates who can purchase the departing owner’s interest, and establishes the purchase price or valuation method.

These agreements are commonly used in partnerships, closed corporations, limited liability companies (LLCs), and when a sole proprietor needs to designate a business successor. There is no need for these agreements in publicly traded companies because the shareholder, or their heirs, can simply sell their stock on the open market.

Why buy-sell agreements are important

Buy-sell agreements serve several critical functions for businesses. They prevent owners from selling their interests to unvetted or unqualified parties without consent from other owners. For example, if a deceased owners’ family members are named as heirs in a will but lack the experience or qualifications to participate in running the business, the buy-sell agreement gives the remaining owners the ability to exclude them. The agreement guarantees a market for their otherwise non-marketable share of the business at a fair price.

These agreements also help establish accurate business value for estate tax purposes, because taxes can take a big chunk of the proceeds a seller receives. 

Finally, for a family business, buy-sell provisions create a structured succession plan that prevents legal battles among heirs and ensures smooth transition of ownership.

Types of buy-sell agreements

• Cross-purchase agreement
• Entity-purchase agreement
• Hybrid agreement
• Cross-endorsement agreement
• One-way buy-sell agreement

Businesses have a number of ways to structure buy-sell agreements, depending on their circumstances or owner goals.

While many buy-sell agreements are funded with life insurance policies for death or disability events, these same agreement types also apply to a partner’s voluntary withdrawal from the business. In voluntary withdrawal scenarios, funding typically comes from installment payments or loans taken out by the remaining partners or designated successors, rather than from insurance proceeds.

Cross-purchase agreement

In a cross-purchase agreement, the individual business owners agree to purchase the departing owner’s interest directly from that owner or their estate. 

Commonly in this agreement type, each owner purchases and owns a life insurance policy on the lives of all other owners. If an owner dies, the surviving owners receive life insurance proceeds and can use the money to buy the deceased business partner’s interest from the estate.

This form of agreement works well for businesses with two or three co-owners of similar age and health status. However, the administrative complexity can increase significantly with more owners. A business with four owners, for example, requires 12 separate life insurance policies.

Entity-purchase agreement

In an entity-purchase agreement, also called a redemption agreement, the business entity purchases a departing owner’s interest. The business may have better access to cash for installment payments in cases of retirement or disability—e.g., making smaller, regular payments to a departing owner instead of a lump-sum buyout.

Typically, the company (instead of individual owners) takes out a life insurance policy on each owner, and is both the beneficiary and the policy holder. If one of the owners dies, the business receives the death benefit and uses it to purchase the deceased owner’s interest. This effectively retires that ownership interest, and the entity-purchase agreement would specify how that interest is redistributed among remaining owners.

Entity-purchase agreements are often preferred when there’s a relatively large number of owners because they only require one policy per owner. This simplifies administration. This structure also works well when there are disparities in the age or health among owners because the company bears the insurance cost burden rather than the individual owners. 

Hybrid agreement

A hybrid agreement, also called a wait-and-see agreement, combines elements of a cross-purchase agreement and an entity-purchase agreement. 

Typically, this arrangement gives the business the first option to purchase a departing owner’s interest. If the business declines to exercise the option, or cannot complete the purchase, the remaining owners have the second option. If neither the business nor the remaining owners purchase the interest, the agreement typically requires the interest to be acquired using some other pre-agreed method, such as life insurance proceeds, third-party financing (e.g., a bank loan or capital investment), or installment payments to the departing owner, rather than requiring the business to purchase an interest it is unable to buy.

The flexibility of the hybrid agreement allows the owners to make the most advantageous choice based on circumstances at the time of a triggering event, rather than when the agreement was signed. In making these decisions, owners might consider tax implications, funding availability, and remaining members’ preferences. 

The downside of a hybrid approach is that it can involve administrative complexity similar to a cross-purchase agreement, especially if funding or alternative mechanisms for purchase must be coordinated among the business, individual owners, or third parties.

Cross-endorsement agreement

In a cross-endorsement agreement, each owner typically purchases their own insurance policy and endorses—or signs over—a portion of the death benefit to other partners or members in proportion to their ownership interests. The other owners pay the policy owner an annual benefit, which offsets their premium costs.

This structure is ideal when business owners anticipate a short-term need for buy-sell coverage, such as when the sale of the business is expected within a few years. Since each member maintains ownership of their own policy, the endorsement can be dropped when buy-sell coverage is no longer needed. At that point, the policy can be repurposed by the holder for future planning, such as retirement income or to provide liquidity for heirs and estate-tax obligations after death. This can be done by placing the policy into an irrevocable life insurance trust (ILIT), which keeps the death benefits outside of the taxable estate, or by simply naming family members or a trust as beneficiaries of the policy in place of a business partner.

One-way buy-sell agreement

A one-way buy-sell agreement is appropriate when a sole business owner wants to designate a successor who doesn’t currently have an ownership interest, such as an employee or family member, who will buy the business interest from the partner or the partner’s estate rather than simply inherit it outright. It can also be used when one co-owner wants to arrange for the sale of their interests to other owners who have no reciprocal desire to sell or arrange a successorship.

The designated buyer typically purchases a life insurance policy on the business owner’s life and pays the premiums. The business may fund these premiums through taxable bonuses to the future buyer. At the insured owner’s death, the successor uses the life insurance proceeds (or the policy cash value for a departure) to purchase their stake at the purchase price specified in the agreement. This way, the insured partner’s estate is still compensated for the value of the business interest, and the interest gets assigned to the partner’s preferred successor. 

Elements of a buy-sell agreement

A comprehensive buy-sell agreement should include several key components to ensure fairness and prevent disputes:

• Owner identification. This names the owners and their current ownership interests in the business.

• Triggering events. Death, disability, retirement, divorce, bankruptcy, or voluntary withdrawal are common events that activate buy-sell provisions.

• Valuation and share purchase-price methodology. Common business valuation methods for determining the fair-market value of ownership interests can include setting a fixed price (which must be regularly updated), obtaining an independent appraisal from a qualified professional, or using a formula based on book value or multiples of earnings.

• Payment terms. Payment may be made in a cash lump sum, through installment payments, with a promissory note that commits to paying a set amount in the future, or via a combination of the three.

• Funding sources. Funds for buying out an ownership interest can include life insurance policies, disability insurance, sinking funds (a savings device when the business or individual owners regularly set aside money for a specific future expense), or business loans.

• Tax implications. This details the tax implications for both the selling owner and purchasing parties. 

• Transfer restriction. This prevents the sale to a third-party purchaser without the consent of other owners.

• Dispute resolution procedures. Such a process is needed if the owners cannot agree on valuation or other transfer terms.

• Periodic review requirement. Changes in the business can necessitate updating valuation to reflect current fair-market conditions.