Common Pitfalls in California Buy-Sell Agreements and How To Avoid Them

If you co-own a business in California, you have probably put significant effort into building the venture. In addition to ensuring business success, you also need a clear succession plan. One of the critical tools for this process is a buy-sell agreement. While a well-drafted one can provide a clear succession path, drafting mistakes can lead to costly financial and legal disputes down the road. Below we explore some of the most common pitfalls business owners face in buy-sell arrangements and how to ensure yours holds up when you need it most.

What is a Buy-Sell Agreement?

A buy-sell agreement is a legally binding contract that outlines what happens to an owner’s share of the business when specific events occur. These events are typically called trigger events and may include death, disability, retirement, bankruptcy, or a decision to sell one’s shares. There are two main types of buy-sell agreements, namely:

• Cross-Purchase Agreement: Each business owner agrees to buy a departing owner’s share, often using life insurance policies.
• Entity-Purchase Agreement: The business buys the departing owner’s interest and redistributes it accordingly.

A properly structured buy-sell agreement can provide a straightforward transition process, minimize disputes, and ensure business stability. However, poorly drafted agreements can lead to serious issues.

Common Pitfalls in Buy-Sell Agreements

Below are some of the most common mistakes in buy-sell agreements.

1. Outdated Terms

One common mistake is relying on a buy-sell agreement drafted years ago. A proper agreement should reflect the current realities of the business according to the prevailing economic conditions, ownership structures, and business value. An agreement that does not account for these shifts can result in unfair buyout terms and significant financial consequences. You can avoid this mistake by reviewing and updating the agreement annually or whenever a significant change occurs within the business.

2. A Generic, One-Size-Fits-All Agreement

Many businesses make the mistake of using a generic template or copying a contract from another company. However, every business has unique circumstances, and a standard agreement may not account for all potential risks in your business. To avoid this, work with a qualified business attorney to create an agreement that fits your business’s specific needs. Also, ensure all owners understand and agree to the terms before signing.

3. Missing or Incomplete Triggering Events

Proper buy-sell agreements clearly outline when they should be enforced. This is where the trigger events come in. If some key triggering events, such as divorce, bankruptcy, or an owner’s exit, are not included, the agreement may not provide the intended protections. Ensure you clearly define all triggering events in the agreement and cover all possible ownership transitions.

4. Lack of Funding for the Buyout

Even if the agreement outlines the buyout terms, it may not include a plan for how to fund the purchase. If an owner leaves or passes away, the business or the remaining owners must determine how to raise funds and may be left relying on current cash flow or borrowing money. To avoid this, life insurance policies, business reserves, and other financing options should be considered as potential sources of funds. If you choose to use insurance, it is wise to ensure the policy ownership and payout amounts align with the agreement’s terms to avoid financial and tax issues.

Contact Us for Legal Help

If you need assistance drafting or reviewing a buy-sell agreement, contact our skilled business attorneys at SAC Attorneys LLP today for guidance and to protect your company’s future.