What it means
Private company shares are hard to sell because there is no market for them, so the moment an owner exits is the moment a private business is most fragile. A buy and sell agreement, sometimes called a buy sell agreement or folded into a wider shareholders agreement, removes the negotiation from that moment by settling the rules while everyone is still friendly.
It is protection against a predictable event, not an exotic legal extra. There are two main structures.
In a cross purchase agreement the remaining owners buy the departing share personally, while in an entity purchase or redemption agreement the company itself buys it back. The choice affects how many insurance policies are needed, the tax cost base of the surviving owners and whether company cash is used.
The price mechanism is the part that causes the most arguments. Common approaches are a fixed value reviewed annually, a formula such as a multiple of earnings, or an independent valuation at the time of the event.
Each has a weakness: fixed values go stale, formulas misbehave in a bad year, and independent valuations cost money and time exactly when a family needs cash. Funding is what turns the agreement from a document into a plan.
Life and disability insurance on each owner is the usual answer, with cover sized to that owner's share of the agreed value, so the cash arrives when the obligation does. The alternatives are a sinking fund, instalment payments out of future profits, or a bank facility arranged in advance.
The nuance most often missed is review. Business values move, owners change, insurance lapses and shareholdings shift, so the agreement and the cover behind it need a scheduled annual check.
A ten year old agreement valuing the business at a third of its current worth is arguably worse than having none, because it is enforceable.
In practice
Real-world examples.
Example
Two sisters own an engineering firm 60 to 40 with a cross purchase agreement valuing it at $4,000,000. When the elder dies, the insurance pays the younger sister $2,400,000, she buys the shares from the estate, and the family receives cash instead of a stake it cannot sell.
Example
A four partner veterinary group uses an entity purchase agreement with a formula price of four times EBITDA, defined in plain words inside the contract. A retiring partner is paid over three years in equal instalments, which protects the practice's cash flow while giving the partner a contractual claim.
Example
A software company's agreement includes a divorce trigger, so when one founder divorces, the shares cannot pass to a former spouse. The other founders have a 90 day right to buy them at the agreed formula price, which keeps the share register with the people running the business.
Formula
Calculation
Two calculations matter: each owner's buyout obligation and the number of policies required. Buyout Value per Owner = Agreed Business Value x Ownership Percentage, and a cross purchase structure needs n x (n - 1) policies for n owners, while an entity purchase needs n.
Three partners own a surveying practice equally, and the agreement values the business at $6,000,000 using a formula of six times normalised operating profit. Each one third stake is worth $6,000,000 / 3 = $2,000,000, so each partner needs $2,000,000 of cover on their life. Under a cross purchase structure the partners insure each other, needing 3 x (3 - 1) = 6 policies of $1,000,000 each, because the two survivors split the $2,000,000 purchase equally. Under an entity purchase structure the practice itself owns 3 policies of $2,000,000, which is simpler to administer but uses company funds and gives the survivors no uplift in the cost base of their own shares.Case study
Seen in the real world.
Ardsley Joinery is an illustrative and clearly fictional cabinet maker owned equally by two cousins, used here to show the cost of an unfunded agreement. They signed a buy and sell agreement valuing the business at $2,800,000 and obliging the survivor to buy the deceased cousin's half, but they never bought the insurance to pay for it.
When one cousin died, the survivor owed the estate $1,400,000 and had $90,000 in the bank. The estate needed cash for tax, the bank would lend only $600,000 against the business, and the eventual settlement was $600,000 up front plus $800,000 over six years with interest, which consumed most of the firm's profit for the whole period.
In this illustrative ending the agreement did its job legally and failed financially. Ardsley survived, but a $4,200 a year insurance premium would have replaced six years of strained cash flow, which is the point most buy and sell discussions should start from.
Watch out
Common mistakes.
- Signing the agreement and never funding it, which leaves a legally binding obligation with no money behind it.
- Writing a valuation formula in vague terms such as fair market value without saying who decides and on what basis, which guarantees a dispute.
- Forgetting disability as a trigger, when a long term illness creates the same problem as death while the owner is still alive and still drawing income.
Questions
People also ask.
What is the difference between cross purchase and entity purchase?
In a cross purchase the owners buy the shares personally and usually gain a higher cost base, while in an entity purchase the company buys them back using its own cash.
How often should the agreed value be reviewed?
At least annually, and immediately after any event that changes the business materially, such as a large contract win or a new shareholder.
Does a buy and sell agreement replace a will?
No, it governs only the business interest, so the will and the agreement must be read together or the estate may be promised something the agreement has already committed.
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