Most multi-member LLCs focus on the present when getting started. While that feels comfortable and practical, it’s just as important when getting set up to think about the future. What happens when members are gone, because they leave, die, become disabled, or have to be removed? You need to be ready with a plan to make the process smooth and keep it from interfering with your business.
A buy-sell agreement is the document that answers those questions before they become emergencies. This article covers what a buy-sell agreement is, how it works, what triggers it, what the disadvantages are, and what it should include.
The short answer: A buy-sell agreement is a contract among LLC members that sets out what happens to a member’s ownership interest if they die, become disabled, leave, or face another triggering event, including who can buy the interest, at what price, and how the purchase is funded. It isn’t legally required, but it’s especially valuable for multi-member LLCs.
What is a buy-sell agreement?
A buy-sell agreement is a legally binding contract between LLC members that governs what happens to a member’s ownership interest when a triggering event occurs. Triggering events usually include death, disability, divorce, retirement, or a voluntary exit.
The main purpose of a buy-sell agreement is to establish in advance who can buy the departing member’s interest, at what price, and under what terms. This can help keep ownership from ending up in the hands of unintended parties and help avoid disputes at an already difficult time.
A buy-sell agreement can be a standalone document or incorporated into the operating agreement. Both approaches are common.
People sometimes call buy-sell agreements business prenups. Similar to a prenuptial agreement, a buy-sell agreement is easier to negotiate when everyone is getting along, and its value becomes clear when things go wrong.
Can an LLC have a buy-sell agreement?
Yes, an LLC can have a buy-sell agreement. In fact, multi-member LLCs commonly use buy-sell agreements.
Without a buy-sell agreement or equivalent provisions in the operating agreement, a member’s ownership interest may pass to their estate, spouse, or heirs, depending on state law. This can lead to uncertainty for the business as those individuals may have no interest in or knowledge of the business, and may be under no obligation to sell.
These are the different forms a buy-sell agreement can take for an LLC:
- Standalone buy-sell agreement: a separate contract between members that governs ownership transfers.
- Operating agreement provisions: buy-sell terms incorporated directly into the operating agreement. This is common for smaller LLCs that want to keep governing documents consolidated.
- Cross-purchase agreement: each member agrees to buy the departing member’s interest personally. This is common in smaller LLCs with two or three members.
- Entity purchase (redemption) agreement: the LLC itself buys back the departing member’s interest. This feels less personal and is more common in larger LLCs.
A business attorney should advise on which structure is most appropriate for a specific LLC’s size, ownership structure, and financial situation.
What triggers a buy-sell agreement?
These are the most common triggers, but an LLC can add relevant events to protect the business.
- Death: the deceased member’s interest normally passes to their estate or heirs. The buy-sell agreement helps the business continue without unintended new ownership, which can disrupt the business and cause future problems.
- Disability: a member who can no longer contribute to the business due to long-term disability. The agreement defines what this means and how long-term disability is determined, and also establishes a process for buying out their interest.
- Voluntary exit: a member who wants to leave can leave, and the buy-sell agreement defines whether remaining members have a right of first refusal and at what price.
- Retirement: a planned exit after a member decides to step back from the business.
- Divorce: in some states, a spouse may be entitled to a share of the membership interest in a divorce. A buy-sell agreement can help address this, for example by requiring any transferred interest to be offered to remaining members first.
- Bankruptcy: a member’s personal bankruptcy may create creditor claims on their LLC interest. A buy-sell agreement can include provisions to help keep a personal financial problem from interfering with business finances.
- Deadlock: some buy-sell agreements include deadlock provisions. A deadlock provision is a mechanism for breaking ties when members can’t agree on a major decision. This matters because it gives business partners a plan for when they don’t agree.
Not every agreement covers every triggering event. The relevant triggers should reflect the specific risks and relationships in the LLC and should consider risks the business may face in the future.
How is the buyout price determined?
There are three main valuation methods, and these are often the most negotiated part of the agreement.
- Fixed price: members agree on a specific price upfront and update it periodically. This method sounds simple but can become outdated quickly if the business grows significantly. If not updated, the fixed price may no longer reflect the business’s value.
- Formula-based: the price is calculated using a predetermined formula, typically a multiple of revenue, EBITDA, or book value. This is a more objective method but requires the formula to remain relevant as the business evolves.
- Independent appraisal: a professional business valuation is conducted at the time of the triggering event. This method is often considered the most accurate but is also typically the slowest and most expensive. An independent appraisal can also lead to disputes if parties disagree with the appraiser’s methodology.
Many agreements combine methods; for example, an LLC may use a fixed price that is reviewed annually, with an appraisal as a fallback if members can’t agree. There may also be tax considerations. A CPA and business attorney should be involved in structuring the valuation method; valuation is a frequent source of buy-sell disputes.
What are the disadvantages of a buy-sell agreement?
Having a buy-sell agreement provides important protection, but buy-sell agreements have real limitations worth understanding.
- Cost to draft: a well-drafted buy-sell agreement typically requires a business attorney and takes time. Every business is different, so there isn’t a simple form to fill out. The upfront cost can feel significant for an early-stage business.
- Valuation disputes: even with a valuation method agreed in advance, disputes about price can happen — particularly if the business has grown significantly since the agreement was last updated or the formula produces a result one party considers unfair.
- Outdated terms: a buy-sell agreement drafted at formation may no longer reflect the business’s reality years later. Ownership percentages may have changed, the business may have grown, or circumstances may have evolved. Agreements that aren’t reviewed and updated regularly can create more problems than they solve. You can make regular reviews part of the agreement.
- Funding the buyout: agreeing that someone must buy a departing member’s interest is only useful if the buyer can afford to do so. Many buy-sell agreements are funded with life insurance, but this requires planning and ongoing premiums. Without a funding mechanism, the obligation to buy exists on paper without the means to follow through.
- Complexity for larger LLCs: as ownership becomes more complex, buy-sell provisions become harder to draft and maintain. Growth is a good sign, but more members, different classes of interest, and outside investors all need to be accounted for.
These disadvantages are manageable with proper planning, but they’re real reasons why some buy-sell agreements that exist on paper don’t work as intended when needed.
What should an LLC buy-sell agreement include?
- Triggering events — which scenarios activate the agreement
- Right of first refusal — whether remaining members must be offered the interest before an outside buyer
- Valuation method — how the buyout price is determined
- Payment terms — lump sum or installments, and over what period
- Funding mechanism — how the buyout will be financed (life insurance, business reserves, installment payments)
- Transfer restrictions — who is and isn’t permitted to receive a membership interest
- Dispute resolution — how disagreements about the agreement’s terms are handled
- Amendment procedures — how and when the agreement can be updated
The operating agreement should be consistent with the buy-sell agreement. Conflicting provisions between the two documents can create significant legal risk. A business attorney should draft the original buy-sell agreement and any later amendments.
If you’re still in the early stages, our guide on how to start an LLC walks through the formation steps, including putting an operating agreement in place, the document buy-sell provisions are often built into or drafted alongside.
How is a buy-sell agreement funded?
Without proper funding, a buy-sell agreement may be difficult to carry out. Funding is a practical concern that determines whether the agreement is actually executable.
- Life insurance: Life insurance is a common funding mechanism for death-triggered buyouts. The LLC or remaining members take out policies on each member’s life, and if one member dies, the proceeds can fund the buyout. This can help keep the business from having to liquidate assets or take on debt. Who owns the policies can have tax and legal implications, so review the setup with an advisor.
- Business reserves: Using this method, the business sets aside funds specifically for potential buyouts. The trade-off is that this capital can’t be used elsewhere in the business.
- Installment payments: A buyout can be paid over time from business cash flow. This method is common when lump sum funding isn’t available, but can create ongoing financial strain.
- External financing: An LLC or remaining members can borrow money to fund the buyout. This has the advantage of preserving business assets, but means taking on debt.
The funding mechanism should be established when the agreement is drafted, not figured out when the triggering event occurs. A financial advisor and business attorney should advise on the right funding structure for a specific LLC’s situation.
Conclusion
A buy-sell agreement is one of the most important documents a multi-member LLC can have, and it can be much harder to put in place fairly once a triggering event has already occurred. The agreement is only as useful as its valuation method and funding mechanism; a well-drafted document with no way to fund the buyout may not solve the problem.
As always, consult a business attorney to draft the agreement and a CPA or financial advisor on valuation and funding. This is an area where failing to plan can be costly, and the right setup from the beginning can help you avoid those problems.
FAQs
No. A buy-sell agreement is optional, but without one (or equivalent terms in your operating agreement), your state’s default rules may determine what happens to a departing member’s interest.
Usually not, since there are no other members to buy the interest. Single-member LLC owners may instead want to address succession in their operating agreement and estate plan.
Many businesses review it periodically, such as annually, and whenever ownership, valuation, or the business changes significantly. Your agreement can set a review schedule.