How to Create a Strong Buy-Sell Agreement With Your Co-Founder
When you’re in the excitement of launching a new business idea, the energy is high, and you don’t want to create any bad vibes by discussing what happens when someone wants to leave. But this is a conversation you need to have. And a buy-sell agreement is how you do it in a way that’s legally binding and not overly emotional.
Think of a buy-sell agreement as a prenup for your business. Nobody wants to talk about it or put one in place. But when the situation arises – and statistically it will at some point – having one in place is one of the best ways to protect each co-founder and their interests.
Before you start drafting anything, bring in a financial professional who specializes in buy-sell agreements. This is not a document you want to pull from a template or piece together on your own. A specialist who has done this many times before will flag issues you wouldn’t think to address. They’ll then help you build something that actually works when it’s needed.
What a Buy-Sell Agreement Actually Does
At its core, a buy-sell agreement establishes the terms under which one co-founder can or must sell their ownership stake to the other. It defines the triggering events, meaning the specific circumstances that activate the agreement. It also establishes how the business will be valued when a trigger occurs. It lays out the payment structure for the buyout and creates a binding framework.
Without a buy-sell agreement, you’re left negotiating the terms of a buyout in real time under whatever conditions exist at the time. For example, one partner wants out during a business downturn. Or maybe a co-founder passes away unexpectedly, and their spouse inherits a controlling stake. Without a pre-existing agreement, any of these situations can become extremely complicated and expensive.
Identify Your Trigger Events
The foundation of a buy-sell agreement is a list of activating events. These need to be specific, clearly defined, and comprehensive enough to cover the scenarios that realistically could arise. Common triggers include:
- Death of a co-founder
- Permanent disability that prevents a co-founder from participating in the business
- Voluntary departure where one partner simply wants to move on
- Involuntary departure due to a serious breach of obligations, criminal conduct, or other defined behavior
- Divorce, where a court might attempt to divide a co-founder’s business interest as a marital asset
- Bankruptcy or personal financial distress that could put a co-founder’s shares at risk of seizure by creditors
- Retirement
Each of these triggers can have its own terms. For instance, a voluntary departure might be handled differently than a death or disability. The agreement should address each scenario on its own terms rather than applying a single set of rules to everything.
Establish a Valuation Method
When a buyout is triggered, how do you determine what the departing co-founder’s share is actually worth? This is the part that generates the most disagreement if it isn’t handled carefully. The method you choose needs to be fair and practical to execute when the time comes.
Several approaches are commonly used.
- A fixed price agreement sets the value in advance and requires periodic updates, typically annually. This is simple but can become outdated quickly in a growing or volatile business.
- A formula-based approach ties the valuation to a specific financial metric like revenue, earnings, or book value multiplied by an agreed-upon factor. This adjusts automatically as the business grows, but can produce results that don’t fully reflect the company’s market value.
- An independent appraisal approach requires a third-party business valuation at the time of the triggering event. This is the most accurate method but also the most expensive and time-consuming, which can create delays.
Many strong buy-sell agreements use a combination of these methods. Your financial professional can help you determine which structure makes the most sense given the nature of your business and how quickly it’s likely to change in value.
Fund the Agreement
A buy-sell agreement is only as strong as the ability to actually execute the buyout. If the agreement says your co-founder’s share is worth $500,000, but neither the remaining owner nor the business has the cash to pay that amount, the agreement is difficult to put into action.
Funding mechanisms solve this problem, and the right one depends on the trigger event. Life insurance is the most common funding tool for death triggers. Each co-founder takes out a policy on the other, and the payout provides the cash needed to purchase the deceased partner’s share from their estate. Disability insurance serves a similar function for disability triggers.
For voluntary departures, retirement, and other non-insurance scenarios, the agreement typically structures the buyout as an installment payment over a defined period rather than a lump sum.
Review and Update Regularly
A buy-sell agreement isn’t something you sign once and file away permanently. As the business grows and personal circumstances evolve, the agreement needs to keep pace.
Schedule an annual review with your co-founder and your financial professional to confirm that the plan is still accurate and makes sense for everyone. This is how you continue to operate a healthy business behind the scenes.
