A buy-sell agreement is more than just a piece of paperwork. It’s a critical safety net that ensures business continuity, protects relationships, and provides financial stability in the event of unexpected changes. Yet, many business owners unknowingly make mistakes when drafting these agreements—mistakes that can lead to costly disputes or business disruptions down the line.
In this article, we’ll explore the most common mistakes business owners make when drafting a buy-sell agreement and provide practical tips on how to avoid them. If you’re serious about protecting your business, pay close attention to these pitfalls.
Mistake #1: Failing to Define Clear Triggering Events
Triggering events are the specific situations that will “trigger” the buy-sell agreement, such as an owner’s death, disability, divorce, retirement, or voluntary exit. Surprisingly, one of the biggest mistakes is not being specific enough about these events, or even worse, not listing them at all.
Why It’s a Problem
Without clearly defined triggering events, there’s ambiguity around when the buy-sell agreement should go into effect. This can lead to confusion and legal disputes among the remaining owners and the departing owner’s family or heirs.
How to Avoid It
Make sure your agreement specifies every relevant triggering event in detail. Consult with your partners and your legal advisor to cover all potential scenarios, including uncommon events like a partner’s bankruptcy or even a criminal conviction. The more specific your agreement, the easier it will be to enforce.
Mistake #2: Not Establishing an Accurate Valuation Method
An inaccurate or outdated valuation can result in significant financial loss for either the departing owner or the remaining owners. If the buyout price is too low, the departing partner’s family may feel shortchanged. If it’s too high, the remaining owners could be left struggling to meet the buyout terms.
Why It’s a Problem
An inaccurate or outdated valuation can result in significant financial loss for either the departing owner or the remaining owners. If the buyout price is too low, the departing partner’s family may feel shortchanged. If it’s too high, the remaining owners could be left struggling to meet the buyout terms.
How to Avoid It
Choose a valuation method that will remain fair over time. Common options include:
Appraisal by an independent third party at the time of the triggering event
Formula-based valuation, such as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
Agreed-upon value that’s updated annually
Be sure to review your valuation method regularly and update it as necessary to reflect the current market value of your business.
Mistake #3: Ignoring Funding Options
A buy-sell agreement without funding is like a car without fuel—it won’t get you anywhere. Too often, business owners create a detailed buy-sell agreement but fail to set up a funding mechanism. This can make it impossible for the remaining partners to afford a buyout when the time comes.
Why It’s a Problem
If there’s no funding plan, the remaining partners may be forced to take on debt, sell business assets, or bring in outside investors to finance the buyout. This can put unnecessary strain on the business and even lead to ownership changes that weren’t anticipated.
How to Avoid It
Consider funding options like life insurance policies, disability insurance, a sinking fund, or a bank loan. Each option has its pros and cons, so work with a financial advisor to choose the best approach for your business. Funding the buy-sell agreement is essential to ensure a smooth transition without financial hardship.
Mistake #4: Not Including a Non-Compete Clause
A non-compete clause prevents a departing owner from starting a competing business or joining a competitor after they leave. It’s a common but critical part of buy-sell agreements, and omitting it can be a costly mistake.
Why It’s a Problem
If a departing partner starts or joins a competing business, they could poach clients, employees, and even proprietary information. This could put the remaining owners at a significant disadvantage, especially if the departing partner is highly knowledgeable about the business’s inner workings.
How to Avoid It
Include a non-compete clause in your buy-sell agreement that specifies a reasonable timeframe and geographic scope. While non-compete clauses can be legally complex, they are enforceable when drafted carefully. Make sure to consult a lawyer to ensure the clause is both fair and compliant with local laws.
Mistake #5: Failing to Regularly Review and Update the Agreement
A buy-sell agreement isn’t a “set it and forget it” document. Businesses evolve, and your agreement should reflect those changes. Unfortunately, many business owners make the mistake of drafting the agreement once and never revisiting it, even as the business grows or new partners join.
Why It’s a Problem
Outdated agreements can create serious issues. For example, if a new partner isn’t included in the agreement, they may be left out of ownership transition plans, leading to disputes or even lawsuits. Additionally, if the valuation method or funding mechanism hasn’t been updated, it may no longer meet the business’s needs.
How to Avoid It
Make it a policy to review your buy-sell agreement annually or whenever there’s a significant change in the business, such as:
A new partner joining
A major business expansion or acquisition
A change in the financial health of the company
An annual review allows you to keep the agreement aligned with your current business structure and goals.
Mistake #6: Using a One-Size-Fits-All Template
In an effort to save time and money, some business owners use a generic buy-sell agreement template. While this might be an easy solution, it often leads to an agreement that doesn’t address the unique needs of the business or its owners.
Why It’s a Problem
Every business is different, with its own ownership structure, financial situation, and growth plans. A generic template may overlook important clauses, contain ambiguous language, or fail to comply with local laws. This can lead to gaps in coverage or leave room for interpretation, making the agreement less effective.
How to Avoid It
Work with an experienced attorney or business consultant to create a customized buy-sell agreement. Tailoring the document to your specific situation ensures that it provides adequate protection and meets all legal requirements. A little extra investment upfront can save a lot of headaches down the road.
Mistake #7: Not Considering Tax Implications
Tax consequences are a crucial aspect of buy-sell agreements, but they’re often overlooked. Different types of agreements (e.g., cross-purchase vs. entity-purchase) have different tax implications for both the business and the individuals involved.
Why It’s a Problem
An improperly structured buy-sell agreement can result in unnecessary tax burdens. For example, an entity-purchase agreement can lead to double taxation, as the business is taxed on profits and then the remaining owners are taxed on dividends.
How to Avoid It
Consult a tax advisor or financial planner when drafting your buy-sell agreement. They can help you understand the tax consequences of each type of agreement and choose the structure that minimizes tax liabilities for all parties involved.
Mistake #8: Overlooking Family Involvement in Ownership Transitions
If a partner passes away, it’s natural for their family to inherit their share of the business. However, this can create challenges, especially if the family members lack experience or have different visions for the business. Many buy-sell agreements fail to address family involvement, which can lead to conflicts.
Why It’s a Problem
If the family decides to actively participate in the business, it could disrupt the established working relationship among the remaining owners. Alternatively, if the family prefers a quick buyout, it could strain the business financially.
How to Avoid It
Specify in the buy-sell agreement whether the family of a deceased owner can remain involved or if their shares should be bought out. This clause should be sensitive yet clear, ensuring a smooth transition while respecting the wishes of the family and the needs of the business.
Final Thoughts: Draft Your Buy-Sell Agreement with Care
Creating a buy-sell agreement that truly protects your business requires careful planning, customization, and regular updates. Avoiding these common mistakes can save you from unexpected disputes, financial burdens, and potential business disruptions. Remember, a well-drafted buy-sell agreement isn’t just a legal formality—it’s an essential tool for long-term security and peace of mind.
At Fortitude Strategic Solutions, we specialize in helping business owners draft, customize, and maintain effective buy-sell agreements. Our team of experts can guide you through every step of the process, from choosing the right funding options to minimizing tax implications.
Ready to safeguard your business’s future? Contact Fortitude Strategic Solutions today to start building