In closely held businesses and professional practices, a buy-sell agreement is one of the most essential planning tools. It establishes a framework for how ownership interests will be transferred when certain events occur, ensures that valuation methods are clearly defined, and sets forth funding mechanisms to carry out the buyout. By providing this structure in advance, the agreement reduces uncertainty, protects continuity, and minimizes the risk of disputes among owners.
This guide examines the most common triggers that activate a buy-sell agreement, explains the valuation methods typically used, reviews the funding approaches that allow the agreement to be executed, and highlights the dispute resolution mechanisms that help avoid costly litigation. A practical clause checklist is included at the end to assist with drafting and review.
Triggers in Buy-Sell Agreements
The foundation of any buy-sell agreement lies in its triggering events, which are the circumstances that compel the transfer of an ownership interest. The death of an owner is perhaps the most common trigger, ensuring that the deceased’s stake can be purchased by the remaining owners or the business rather than passing to heirs who may lack the ability or desire to participate in operations. Disability is another important event, as a long-term or permanent inability to work can compromise business performance and necessitate a transition. Divorce may also give rise to complications, since ownership interests could otherwise be transferred to a former spouse through a marital settlement.
Deadlock provisions are particularly significant in companies with two equal owners, where the inability to reach consensus can paralyze operations. By specifying a buy-sell mechanism in advance, the business can continue without prolonged disputes. In regulated professions, license-related issues such as disbarment, medical board sanctions, or other loss of professional standing may also require a forced transfer, since an unlicensed individual cannot legally maintain ownership in certain enterprises. By identifying these triggers with clarity, the agreement provides certainty and prevents disruption when challenging circumstances arise.
Valuation Methods
A buy-sell agreement must also establish how the value of an ownership interest will be determined when a transfer occurs. Several approaches are commonly used. The book value method relies on the company’s balance sheet, calculating net worth by subtracting liabilities from assets. While straightforward, this approach may not reflect the true market value of the business. An alternative is the multiple of earnings method, which applies an agreed multiplier to the company’s earnings—often based on EBITDA or net income—providing a valuation more closely tied to profitability.
For greater accuracy, some agreements rely on an independent appraisal conducted by a third-party professional. Though more costly, this method provides an objective measure of fair market value and reduces disputes. To maintain relevance, many agreements require valuations to be updated periodically, and they establish procedures for resolving discrepancies if the parties disagree. Clearly defining the valuation method is essential, as it directly impacts fairness and predictability.
Funding the Agreement
Valuation provisions are only effective if there is a clear funding plan to support them. Two primary approaches are used: cross-purchase agreements and entity-purchase agreements. In a cross-purchase arrangement, the remaining owners agree to buy the departing owner’s interest directly. This structure often relies on life or disability insurance policies, with each owner holding policies on the others. While effective in businesses with few owners, this model becomes more complex as the number of owners increases.
In contrast, an entity-purchase or redemption agreement places the obligation on the business itself to buy back the ownership interest. The company typically owns the necessary insurance policies and uses the proceeds to fund the purchase. This approach is simpler to administer when there are multiple owners, as the business handles the transaction directly. Regardless of the structure, a buy-sell agreement must ensure that adequate liquidity is available so the transfer can occur without straining the company’s financial stability.
Dispute Resolution
Even with careful drafting, disputes may still arise regarding valuation, the application of triggers, or the terms of payment. To mitigate these risks, most agreements include dispute resolution provisions. Mediation allows the parties to resolve disagreements with the assistance of a neutral facilitator, while arbitration provides a binding decision without resorting to court proceedings. In valuation disputes, an agreement may also provide for expert determination by an independent appraiser whose decision is final. Establishing these mechanisms in advance helps reduce uncertainty, control costs, and preserve business relationships during periods of transition.
Clause Checklist for Buy-Sell Agreements
A comprehensive buy-sell agreement should address several critical areas. It must clearly define the triggering events, such as death, disability, divorce, deadlock, or loss of a professional license. The valuation method should be specified, whether by book value, multiple of earnings, or independent appraisal, and procedures for periodic updates or dispute resolution should be included. Funding arrangements must be described, outlining whether the agreement is structured as a cross-purchase or entity redemption and identifying the role of insurance in providing liquidity—payment terms, whether lump sum or installment, should also be established. In addition, the agreement should address non-compete obligations, transfer restrictions, buyout procedures, and tax considerations. Finally, the dispute resolution process must be clearly set forth, ensuring that any conflicts are handled efficiently.
By incorporating these provisions, a buy-sell agreement creates a reliable roadmap that protects the business, the owners, and their families in times of transition.
How Our Firm Can Help You
At Leiva Law Firm, we recognize the critical role that buy-sell agreements play in maintaining stability and protecting value in privately held businesses. Our attorneys have extensive experience drafting, reviewing, and negotiating these agreements to ensure that every essential detail is addressed with clarity. Whether you are establishing a new deal or updating an existing one, we can assist with identifying potential risks, tailoring valuation and funding mechanisms to your needs, and safeguarding your long-term interests.
Contact us today at (818) 519-4465 to schedule a consultation with our experienced agreement lawyers in Los Angeles and learn how we can help you implement a buy-sell agreement that provides certainty and security for your business.
