Terms Beginning With 'b'

Buy-Sell Agreement

What is a Buy-Sell Agreement?

An agreement or a legally binding contract that governs the situation if a business partner dies or otherwise leaves the business is termed as a buy-sell agreement. Such an agreement is designed to provide for the organized disposition or continuation of a person's ownership in a business.

The buy-sell agreement is also called a ‘buyout agreement’, which reflects what will happen to the shares of an enterprise when an unforeseen event occurs. Sometimes, it is also known as the ‘business will’ as it is concerned with the succession of an enterprise or business at the time of a crisis.

What are the Events that Can Trigger the Buy-Sell Agreement?

A buy-sell agreement is formed to ensure the successful run of transactions during certain triggered events, which can result in a potential disaster. These events majorly comprise:

  • Divorce: Amidst the growing frequency of divorce in today’s world, a buy-sell agreement often contains divorce as an activating event. This is done to ensure that a non-employee spouse is not provided with an ownership in the shares of a company post-divorce.
  • Disability: In circumstances where a shareholder becomes disable and incapable of performing company’s duties, a buy-sell agreement can provide clarity on the meaning of disability and the length of time before disability prompts a buyout.
  • Death: A buy-sell agreement is often created to resolve issues at the time one of the owners passes away. The agreement can provide a tool on delineating the value of shares for the purpose of estate taxes and their dissemination to other surviving members or family post owner’s death.
  • Bankruptcy: At the time an owner declares insolvency or bankruptcy, a buy-sell agreement can enable the remaining shareholders to buy his or her shares to prevent their dissemination to creditors.
  • Retirement: A retiring shareholder can cash-out his or her possessed interest through a buy-sell agreement. Usually, the remaining shareholders do not want a retired stockholder to harness the benefit of their ongoing efforts. Hence, either a current shareholder purchases his shares, or the shares are put up for a bid.

What are the Different Kinds of Buy-Sell Agreements?

Buy-sell agreements can be broadly classified into three categories – cross-purchase, redemption and hybrid agreement.

  • Cross-Purchase Agreement: Such an agreement enables a firm’s owners or other shareholders to buy the stake or shares of a partner who becomes disabled, dies or retires, at a certain price.
  • Redemption Agreement: Such an agreement allows the company’s owners to ascertain in advance the terms of transferring or purchasing ownership stakes in the event of a departure of an owner from a company. In this agreement, the company itself is obligated to purchase the shares of a deceased or exiting owner.
  • Hybrid Agreement: An integration of cross-purchase and redemption agreement is termed as hybrid agreement or ‘wait and see’ agreement. In such agreement, both business and the remaining owners can buy the interest of the exiting or deceased owner at a pre-determined price.

Why are Buy-Sell Agreements Important?

In order to facilitate the systematic transfer of business interests in case of occurrence of some specific events, the business partners prefer to enter into a buy-sell agreement. Below are some of the key advantages associated with the buy-sell agreement:

  • Defines ownership succession plans and the desired exit strategy.
  • Prevents obstruction in the voting control of the business and a tiff in the management.
  • Minimises the risk of a departing owner or the related family members, taking a legal action over the company’s valuation.
  • Prevents the threat of a departing owner’s spouse selling their share of the business to an unsatisfactory third party.
  • Makes sure that the survivor of a deceased business partner is paid compensation for the deceased partner’s share in the business.

How are Buy-Sell Agreements Funded?

The buy-sell agreements are usually funded by purchasing insurance policies, with numerous options in place for policy ownership:

  • Self-ownership: The person insured is the owner of the policy in this case. In this case, the departing owner is usually required to give up his or her interest in the company to existing shareholders upon departure, with the leaving owner receiving policy proceeds. It is considered as the simplest structure in which the insured person controls the policy even if he leaves the business.
  • Cross-ownership: The business owners hold policies on each other in cross-ownership. Such ownership varies with changes in ownership of the business. In this case, when a trigger event occurs, the continuing owners generally use the policy proceeds to buy the departing owner’s interest in the business.
  • Insurance Trust: An insurance trust is the owner of the policies on account of all business owners in this case. Herein, policy ownership is unaffected by the changes in business ownership. In case a trigger event occurs, the trust can dispense the policy proceeds to the existing owners.
  • Business Entity: In this case, the trading entity is the owner of policies on behalf of the business owners. Unless and until the insured person does not want the policy assigned to him while leaving the business, policy ownership is unaffected by the changes in business ownership.

How to Choose an Effective Buy-Sell Agreement?

Once the owners reach a decision that the buy-sell agreement is required, it is imperative to choose an appropriate agreement. Typically, an influential buy-sell agreement answers the following queries:

  • Who can hold a stake in the business?
  • What occurrences will cause the obligation to sell or buy a stake in the business?
  • What will be the procedure for assessing the shares?
  • What will be the terms of the transaction and the purchase price of the shares?
  • How will the agreement be funded?

What is earnest money? Earnest money refers to a sum of money that is paid by the buyer to the seller as a form of reassurance of future payments during the sale of a house. Paying earnest money is also beneficial to the buyer because it gives him leverage to arrange the remaining funds. Earnest money can be deposited via a direct home deposit, an escrow account or in the form of good faith money. How does earnest money work? Earnest money is paid before closing on a house sale. When the seller and buyer come to an agreement on the house sale, the seller must take the house off the market. Earnest money serves the purpose of assuring the seller that the deal would not fall through. The amount paid as earnest money is usually 1-3% of the total sale value of the house. Most sellers prefer to hold earnest money in an escrow account. In case the deal does not materialize, the money can be given back to the buyer directly from the escrow account. This removes the concerns any buyer may have about whether the money would be returned by the seller or not. In case the buyer and seller go ahead with the sale, the earnest money becomes a part of the down payment. Thus, the buyer would only pay the remaining amount of the down payment. However, in case the agreement does not materialize between the buyer and the seller, the earnest money is returned to the buyer after deducting the escrow fees from it. With money locked in on one house, buyers are less likely to close a deal with any other house seller. How is the amount of earnest money decided upon? The percentage of the total amount that can be taken as earnest money varies from state to state as policies are different. Additionally, the market scenario is also a major factor affecting the amount of earnest money to be paid. Under normal conditions, 1-2% of the total sale value can be taken as earnest money. However, if the market does not have a high demand for houses, then the percentage charged as earnest money could be lower around 1%. In markets with high demand, this percentage could be as high as 3%, or even 5%. To outbid other buyers, one can pay a larger sum of money as earnest money. This would increase the buyer’s chances of securing the property. Why is earnest money important? Earnest money may not always be mandated by the seller, but in a highly competitive market earnest money may be necessarily required. Paying the earnest money makes the agreement official. Without earnest money, the deal may not be considered official in many regions. It is one of the four stages of payment while making a deal on a house. However, in certain instances, even after the payment of the earnest money, the deal may not materialize. Typically, a buying agent should be able to assist the buyer in such a case. What conditions must be met for earnest money to be refundable? Earnest money has certain contingencies attached to it for the protection of both the seller and the buyer. Even after the seller has accepted the earnest money deposit, there are certain contingencies that must be met before the deal can be finalized. These include the following: Home inspection contingency: This contingency is placed so that buyers can back out of the agreement in case the there are some faults in the property, and it is in need of repair. However, it is not necessary for the buyer to call off the deal in such a case. He can simply work with the seller to reach a mutual decision rather than scraping away the deal completely. Financing Contingency: It might be the case that a buyer had not been approved for a mortgage before making the earnest deposit. Here the financing contingency would protect the buyer. If the mortgage does not get approved even though the earnest money had been paid, then the financing contingency allows the buyer to walk away from the deal along with the refunded earnest money. Appraisal Contingency: This protects the buyer in case the property has been overvalued. Here the lender can hire a third-party investigator who can examine whether the property has been priced at a fair value or not. If the value of the house comes out to be higher than the fair value, then the buyer can walk away with a refund. Additionally, this contingency can be used to bring down the price of the sale too. Contingency for Selling the Existing home: It is quite possible that contracts are made based on whether the buyer can sell an existing home or not. If the buyer is unable to sell the existing home, then he can walk away with a refund. These contingencies can be waived by the buyer in case he is sure that the deal would close and there would be no backing off. However, it is important to note that contingencies can provide an extra cushion against adverse circumstances and they might come in handy in certain cases. What is the difference between earnest money and good faith deposit? Both terms can be used interchangeably. However, all good faith deposits are not the same as earnest money. A good faith deposit can be made directly to the mortgage lender, while earnest money is usually held in an escrow account. Both serve the purpose if providing a sense of security about the buyer sticking to the same deal and not going elsewhere. The good faith deposit eventually forms a part of the lending process. However, in case the deal does not materialize, it is possible that the borrower would not get his good faith deposit back.

Negotiable is generally referred to as the unsettled price of a good or security, or a condition or provision or term in a contract or an agreement that is not resolute between the parties and has room for adjustment.

Fair value in investing means that the knowledgeable buyer and seller enter into the agreement and agreed upon the asset's sale price.

An immediate annuity is an insurance agreement that provides income over time depending on assets provided to an insurance firm

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