If you own a business with one or more partners, there is a question you should be able to answer: What happens to my ownership interest if one of us dies, becomes disabled, retires, or simply wants out?

If the answer is “I’m not sure,” you are not alone. Many successful businesses operate for years without a meaningful buy-sell agreement. The owners are focused on running the company, growing the business and taking care of customers. Everyone assumes they will figure out the ownership issue when the time comes.

That is when problems can become much more difficult to solve.

A buy-sell agreement establishes the rules for what happens when an owner’s interest needs to change hands. It can provide a roadmap for the remaining owners, the departing owner and the departed owner’s family. For a closely held business, it can be one of the most important planning documents the owners have.

What Happens When an Owner Leaves?

Consider a manufacturing company owned by three partners. One partner unexpectedly passes away. Without an agreement, the deceased partner’s ownership interest will pass according to his or her estate plan. The surviving partners could find themselves in business with a spouse, children or other heirs who have never been involved in the company.

That may create a difficult situation for everyone involved. The family may want the full value of the ownership interest, while the remaining owners may want to maintain control of the business. Everyone may have legitimate interests, yet the parties can have very different ideas about what should happen next.

A properly designed buy-sell agreement can address these issues before they arise. It can establish who has the right or obligation to purchase the interest, how the purchase price will be determined, and how the transaction will be funded. The same basic planning can apply when an owner retires, becomes disabled, divorces or decides to leave the business voluntarily.

How Will the Ownership Interest Be Valued?

One of the most important provisions is also one to which owners sometimes give too little attention: determining the value of the ownership interest.

Simply stating that an interest will be purchased for “fair market value” may leave significant questions unanswered. How will fair market value be determined? Who makes that determination? As of when is the value established? What happens if the owners disagree?

There are several ways to address these questions. Owners may agree on a value periodically, establish a formula or require an independent valuation when a triggering event occurs. The appropriate approach depends on the business, its ownership structure and the goals of the owners.

The important point is to establish the process while everyone is working together. Business values can change dramatically over time. An agreement that made sense when a company was worth $2 million may be inadequate when the company is worth $20 million. The agreement should therefore be reviewed periodically to make sure the valuation provisions still make sense.

How Will the Purchase Be Funded?

Determining the value is only part of the problem. The next question is how the purchase will actually be paid for.

Life insurance is often used to provide liquidity when an owner dies. Other situations may involve available cash, installment payments, borrowing, or some combination of these approaches. The funding mechanism needs to work with the terms of the agreement and the financial realities of the business.

For example, an agreement requiring the remaining owners to purchase a $5 million interest may provide little practical protection if those owners have no realistic way to finance the transaction. Funding should be considered when the agreement is created, rather than after the triggering event occurs.

The Tax Consequences Matter

There can also be significant tax consequences associated with a buy-sell arrangement. The treatment can depend on the type of entity, whether the transaction involves an equity interest or assets, the reason for the transaction and the specific terms of the agreement.

That is why your Friedman+Huey advisor and attorney should work together when the agreement is drafted and when it is materially changed. The legal documents, valuation provisions, insurance coverage, financing arrangements, tax consequences and estate plan should work together as part of the overall ownership transition strategy.

The same attention should be given to voluntary departures. An owner may decide to retire while the other owners want to continue running the business. One owner may receive an offer to sell his or her interest to an outside party. The owners may disagree about the future direction of the company.

A well-designed agreement can establish a process for dealing with those situations before the owners are negotiating under pressure. That can be particularly valuable in a family-owned business, where financial decisions can also affect personal relationships.

Review the Agreement as the Business Changes

One of the biggest mistakes owners can make is putting a buy-sell agreement in a drawer and forgetting about it.

Ownership changes. Business values change. Debt and financing arrangements change. Insurance policies expire or become inadequate. Owners’ personal circumstances change and estate plans are updated. The agreement needs to keep pace with those changes.

At least periodically, the owners should take the agreement out and ask whether it still reflects the business as it exists today. Are the owners the same? Is the valuation method still appropriate? Would the funding actually be available? Do the insurance policies still provide the intended coverage? Does the agreement coordinate with the owners’ current estate plans?

These questions are much easier to address while the owners are getting along and the business is operating normally.

F+H Advisor’s Insight

A buy-sell agreement is really about making sure everyone knows what happens when something changes.

The best time to negotiate difficult ownership questions is when the owners are working well together and the business is doing well. Once a death, disability, retirement or ownership dispute occurs, negotiating the rules from scratch can be expensive, stressful and disruptive.

If you own a closely held business with partners or family members, take your buy-sell agreement out of the drawer and read it. Then ask yourself one simple question:

If something happened tomorrow, would this agreement actually work?

At F+H, we work with business owners and their legal and financial advisors to evaluate the tax and financial aspects of ownership transition planning. A buy-sell agreement is one part of a larger succession plan, and it deserves the same attention as any other major business decision.