A well-drafted buy-sell agreement helps answer those questions before they become disputes. Often described as a form of corporate divorce planning, a buy-sell agreement establishes how ownership interests may be transferred, how the business will be valued, and how future transitions will be handled. By addressing these issues in advance, business owners can help reduce conflict, protect the company’s continuity, and support long-term business succession planning.
The 5 D’s That Every Buy-Sell Agreement Should Address
Many buy-sell agreements address only death or retirement. While those situations are serious, they represent only a small portion of the events that can disrupt business ownership. A comprehensive agreement should establish clear procedures for several common situations before they occur.
Death
When an owner dies, their ownership interest may otherwise pass to heirs or a surviving spouse who was never intended to participate in the business. A buy-sell agreement establishes how those ownership interests will be transferred and helps provide continuity for the remaining owners.
Disability
Not every disability is permanent, and not every illness should trigger a buyout. A well-drafted agreement clearly defines when an owner lacks the capacity to continue fulfilling their responsibilities and explains when a purchase of their ownership interest may occur.
Divorce
Without appropriate planning, a divorce may raise questions about whether an ownership interest is a marital asset subject to distribution. Buy-sell agreements should include provisions designed to help prevent an ex-spouse from acquiring voting rights or operational control of the business.
Disagreement
Even successful and friendly business partnerships can reach an impasse. A buy-sell agreement may include deadlock provisions that establish procedures for resolving disputes or provide a structured path for one owner to exit the business if an agreement cannot be reached.
Departure
Owners sometimes retire, pursue other opportunities, or leave the business under difficult circumstances. Whether the departure is voluntary or involuntary, a buy-sell agreement should establish how ownership interests will be valued, transferred, and paid for before such situations arise.
There are a number of items that should be included in a buy-sell agreement. Really, first and foremost, are the triggering events. So, when does the buy-sell agreement actually trigger and come into play?
Establishing a Valuation Formula Before a Dispute Arises
One of the most common mistakes in a buy-sell agreement is postponing the valuation question until after a triggering event occurs. Language stating that the purchase price will be determined “by mutual agreement” may seem reasonable when everyone is getting along, but it often becomes a source of conflict when emotions are high.
Instead, an effective agreement establishes a valuation method in advance so every owner understands how the business will be valued if a buyout becomes necessary. Below are the three most common valuation methods:
Valuation Method | How It Works | Often Best For |
Fixed Price | The owners agree on a specific value and update it annually. | Newer businesses that can consistently review and update the agreed value. |
Formula-Based | The agreement applies a predetermined financial formula, such as a multiple of EBITDA or another agreed-upon metric. | Service businesses or companies with predictable financial performance. |
Independent Appraisal | A certified business appraiser determines the value when a triggering event occurs. | Established companies with changing values, significant assets, or rapid growth. |
Funding the Buyout
Determining who has the right to purchase an ownership interest is only part of the equation. The agreement should also address how that purchase will actually be funded. Without a funding strategy, even a well-written buy-sell agreement may place significant financial strain on the business or its remaining owners.
Common funding methods include the following:
- Life and disability insurance: Insurance proceeds may provide the funds needed to purchase an owner’s interest after death or a qualifying disability, helping avoid large, unexpected cash demands on the business.
- Installment payments: Rather than requiring a single lump-sum payment, the agreement may allow the purchase price to be paid over time according to predetermined terms, making the transition more financially manageable.
Selecting an appropriate funding method helps ensure that the buy-sell agreement can be executed when it is needed most.
“We have to get the funding mechanisms in place for our buy-sell agreement. That can be in the form of life insurance to provide for an influx of cash upon death or a promissory note to where the business or the surviving owner pays out the exiting owner over a period of years.”
Rights of First Refusal and Transfer Restrictions
Business owners typically invest significant time choosing partners who share their vision, values, and long-term goals. A buy-sell agreement helps preserve that relationship by limiting when ownership interests may be transferred to outside parties.
One of the most common provisions is a Right of First Refusal, or ROFR. Before selling an ownership interest to a third party, an owner must first offer those shares to the remaining owners or the business itself under the same terms. Only if they decline may the ownership interest be sold to someone else.
Transfer restrictions may also address other situations in which ownership could change unexpectedly, helping to ensure the business remains under the control of individuals the owners know and trust.
The Texas Shootout Clause
Not every business dispute can be resolved through negotiation. In some situations, owners simply reach a point where they can no longer work together, creating a deadlock that prevents the business from moving forward.
Rather than forcing the owners into lengthy litigation or judicial dissolution, some buy-sell agreements include what is commonly known as a “Texas Shootout Clause.”
Although the details can vary from one agreement to another, the basic concept is straightforward. One owner offers to purchase the other’s interest at a specified price. The receiving owner must then either accept the offer and sell their interest or purchase the offering owner’s interest using the same valuation. Because either party may ultimately become the buyer or the seller, both owners have an incentive to propose a fair price.
While a Texas Shootout clause is not appropriate for every business, it can provide a structured method for resolving deadlocks while helping the company continue operating.
Create Your Buy-Sell Agreement Today
The most effective buy-sell agreements are drafted long before they are ever needed. Taking the time to address ownership transitions today can help your business navigate tomorrow’s challenges with greater clarity and confidence.
At Evans & Davis, we help business owners prepare for the unexpected by developing buy-sell agreements that reflect their company’s unique ownership structure and long-term goals. Our business law attorneys work with clients to evaluate the ownership risks, develop practical succession strategies, and design solutions that protect both the business and the people behind it.
Call 866-708-2335 or contact us online to devise a buy-sell agreement that supports your business today.
