Three common mistakes made with buy-sell agreements
Buy-sell agreements offer protection for the transfer of ownership interests in a business. Don’t get tripped up by the three most common pitfalls in these contracts.
A buy-sell agreement is a contract that formally documents the terms related to the transfer of ownership interests in a business. It’s a great way to ensure ownership transition meets the goals of owners and their families, as well as to protect their financial interests. But they’re not without potential pitfalls.
When a buy-sell agreement is not updated regularly, the terms may not align with the owner’s current situation or future goals.
Here are three common mistakes owners often make.
- Owners allow the agreement to become stale.
When a buy-sell agreement is not updated regularly, the terms may not align with the owner’s current situation or future goals. One of the most important items to consider is the value of the business defined in the agreement. If the value, or the method for determining the value of the business, are not reviewed and updated regularly, the risk is high that an exiting owner will not receive the appropriate purchase price for his or her interest.
- The agreement does not include real estate.
Oftentimes real estate — which can be critical to continued business operations and an organization’s future success — is held outside of the operating company. When agreements are drafted and the real estate is not held by a party subject to the agreement, the real estate is also not subject to the terms of the buy-sell agreement. It’s essential that all real estate, and other entities, are included in the planning.
- The buy-sell is unfunded, or the funding isn’t structured properly.
Many times a buy-sell agreement requires a buyout of ownership interests upon the triggering event (death, disability, divorce, etc.). However, no planning may have been done by the business for how to fund the buyout. When the event occurs, the company must then determine how it will obtain the funds to meet the obligation, oftentimes relying on current cash flow or borrowing funds. In the event of a death or disability, this can often be addressed with the purchase of an insurance policy. If insurance is used, however, it is essential to ensure that the terms of the agreement match the terms of the insurance. All too often, the insurance is not owned by the right party, or funded for the right amount, both of which can cause financial and tax issues.
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