Buyout Agreements 101: A Beginner’s Overview

For many businesses, bankruptcy signals the end of the road. But not for Fuse Media.

After its 2019 bankruptcy filing, Fuse Media, an entertainment company, found a lifeline when its leadership team bought the company from its private equity and hedge fund owners. This move not only saved Fuse Media financially but also preserved its diversity mission and Latinx identity. 

Bankruptcy isn’t the only situation that can force business owners to sell their shares. Retirement, disability, death, and more can lead to ownership change. Without proper planning, the business might struggle to find a suitable buyer or risk being acquired by the wrong people. That’s where a buyout agreement comes in; a document that outlines who can buy an owner’s share and under what conditions.

Keep reading to learn how different types of buyout agreements work,, their advantages, the clauses to include, and the steps to create clear, fair, and legally compliant ones.

What is a Buyout Agreement and How Does it Work?

A buyout agreement, also known as a buy-sell agreement, is a legally binding document that governs the transfer of business ownership when certain events occur, such as an owner’s voluntary departure, retirement, disability, death, or other unexpected situations.

The agreement outlines clauses like triggering events, valuation methods, and funding mechanisms like installment payments, life insurance, or company reserves. These elements ensure clarity and fairness in the transfer process while safeguarding the business and the interests of the parties involved.

If a partner violates a buyout agreement by refusing terms, disputing valuations, or missing payments, the aggrieved parties may pursue legal action. Courts generally uphold buyout agreements that are fair and compliant with state laws. Remedies can include compelling compliance, awarding damages for breach of contract, or forcing sales of the shares.

The Types of Buyout Agreements to Consider

Don’t just create a buyout agreement; consider factors like ease of administration, tax implications, and business structure. This requires you to understand the three main types of buyout agreements to choose the best fit. They include:

Cross-purchase buyout agreement

A cross-purchase agreement allows the remaining owners to buy a departing owner's shares. The primary goal of this arrangement is to keep ownership within the existing group of owners.  

One reason to consider a cross-purchase agreement is the tax benefit from a “step-up in basis”. This means the price you bought the shares becomes the new starting point for calculating future taxes, reducing the taxable profit. For example, if you buy a share for $100,000 that an original owner bought at $50,000. If you later sell it for $120,000, the tax is on the $20,000 profit instead of $70,000.

Cross-purchase agreements are hard to manage when you fund them with life insurance, as each owner must hold policies on others (e.g. five owners require 20 total policies). To solve this, you can use entities like an insurance-only LLC or a business continuation general partnership to manage the policies collectively. Also, as a young owner, you may pay higher insurance premiums for older partners due to higher medical and mortality risks. 

Entity purchase buyout agreement

An entity purchase agreement, or a redemption agreement, enables the business or entity to buy a departing owner's shares. With the entity as the sole buyer, the process becomes simpler, avoiding the complexity of aligning the agreement with multiple owners. 

After the entity acquires the share, it can keep or redistribute it among the remaining owners. 

In an entity purchase agreement, the business typically uses life insurance proceeds to fund a buyout, which is usually tax-free. However, the Connelly v. IRS case revealed a tax complication. Michael and Thomas Connelly, owned Crown C Supply and had an entity purchase agreement for their shares. After Michael Connelly passed away, his estate (total value of a person's assets, liabilities, and property at the time of their death) excluded the insurance payout from his share’s valuation, but the IRS included them, raising his estate’s taxable value. 

The courts, including the Supreme Court, sided with the IRS, ruling that life insurance payouts increase a business’s value and should be factored into the estate tax calculation. This highlights the need to carefully consider the tax implications of using life insurance in entity purchase buyout agreements.

Wait-and-see buyout agreement

A wait-and-see agreement is a flexible buyout arrangement that allows a business and its owners to delay committing to a specific buyout method until a triggering event occurs. 

Typically, the agreement outlines a sequence of purchase options:

• First Option: The business entity has the first right to redeem the departing owner’s interest
• Second Option: If the business declines, the remaining owners can purchase the interest individually pro-rata or in a specified order
• Third Option: If neither the business nor the owners exercise their options, the agreement allows the shares to be sold to an outside party, subject to approval

While this agreement ensures that owners are not locked into a rigid buyout method in advance, it can lead to delays or disputes, as different parties may have varying preferences for how the buyout should be handled.

To avoid disputes, when drafting a wait-and-see agreement, define the sequence of purchase options and set deadlines for exercising the options.

Key Use Cases for Buyout Agreements to Future Proof Your Business

According to Sigma reports, nine out of ten businesses believe succession planning (which includes buyout agreements) is worth the investment. However, it's not just the business that benefits, the departing owner also enjoys fair compensation.

Let’s dig into how buyout agreements help both parties in the following scenarios:

Permanent disability or illness

If a permanent disability prevents an individual from managing a business, a buyout agreement ensures the sale of their share at a fair price. This provides financial security during a challenging time while enabling the business to continue.

Career change

A buyout agreement offers a clear pathway to exit a company that no longer aligns with your passions. You sell your stake, receive fair compensation, and pursue new interests while saving the business from potential underperformance. 

For example, Richard Branson, founder of Virgin Records, sold his stake to EMI Records in 1992. This buyout secured him the funds to expand Virgin Atlantic Airways.

Retirement

Since retirement is often planned, you as the retiring owner typically have time to choose a successor who shares similar values. You can work alongside the successor to ensure a smooth transition.

For example, Workman and Associates announced their retirement, passing the reins to Matt Jegins, an employee, through a buyout agreement having ensured that he upheld the company’s core philosophy.

Retirement also accommodates a gradual transition. You can choose a multi-year buyout plan, allowing you to remain involved as a consultant while providing the remaining owners with a manageable payout structure. 

Death

Although it may be uncomfortable to discuss, planning a buyout agreement against an owner's sudden death is crucial. It ensures that the business doesn't fall into the hands of someone misaligned with its values or operations. It also guarantees that the bereaved family is fairly compensated while minimizing the impact of the person’s departure.

Divorce

If your business is family-owned or ownership is considered marital property (usually when there’s no prenup), divorce can lead to messy disputes over ownership, potentially harming the business. 

In Hoffman v. Hoffman, a divorcing couple faced disputes over their failing auto parts business. The court awarded full ownership to the husband, along with all the debt, despite the wife's  claim that it was unfair. The court based its decision on the husband's greater control and investment in the business.

Had a clear buyout agreement been in place, it may have prevented the dispute and financial strain that followed.

Bankruptcy

When a shareholder faces bankruptcy, a buyout agreement can help navigate the situation. 

In the case of personal bankruptcy, the owner could easily liquidate their share to pay off creditors and restore financial stability. Similarly, if the company goes bankrupt, the buyout agreement could trigger a sale of the owner’s share, helping the business regain its footing quickly, much like the case of Fuse Media.

Termination of an employee 

It’s nice to offer employees stakes in your business as part of compensation packages. However, when they leave voluntarily or due to termination, a buyout agreement allows you to buy back the shares.

For example, Stellantis, an automobile manufacturer, recently offered buyouts to salaried employees to mitigate the impact of challenging market conditions. The buyout allowed the company to regain control over its ownership structure and better align it with the company's present needs.

Why Do You Need a Buyout Agreement?

Sigma report also states that 60 percent of business leaders acknowledge the high risk of not having a succession plan, and 48 percent recognize that succession planning offers significant cultural, operational, and financial benefits. Let’s dig into some specific advantages:

Insulates business stability and continuity during uncertainties

With a succession plan, unexpected events like sudden death or mental illness can disrupt business operations and risk losing key employees and customers .

For example, Apple’s Steve Jobs planned nomination of Tim Cook ensured a smooth takeover after his retirement. However, an unplanned event could have led to chaos and poor leadership choices.

A buyout agreement that pre-defines ownership transitions mitigates such risks, ensuring stability during crises. 

Ensures fair valuation

As a departing owner, assessing your share’s value is key to determine a buyout price. Without a clear, predetermined valuation method, rushed decisions can result in undervalued or unaffordable buyouts.

A buyout agreement ensures a fair agreed-upon valuation, promoting fairness and preventing conflicts.

Controls ownership transfer 

A buyout agreement is essential for controlling ownership transfers and protecting your business’s identity and success. Without clear guidelines, shares could fall into the hands of competitors or individuals with conflicting goals.

Fuse Media mentioned in the introduction, it wasn’t just about saving the company from the brink of bankruptcy but also about preserving its Latinx cultural identity. To achieve this, the management triggered a buyout to ensure a Latinx owner. 

Such agreements ensure ownership remains in trusted hands. It could also include a clause that prevents a competitor from buying into the company, which is especially important for protecting intellectual property, trade secrets, and strategies.

Facilitates faster and dispute-free transfers 

Pre-arranged buyout terms streamline ownership transfers by outlining specific conditions such as how the shares will be sold and to whom. This removes the need for extensive negotiations or bidding wars in critical moments, facilitating a faster, smoother process. 

In the sports industry, buyout clauses often provide a clear and direct transaction pathway. For instance, Marcus Thuram is tied to a €85 million buyout clause with Inter Milan. This clause allows any club to acquire him by paying the specified price, bypassing protracted negotiations with his current club.

What Should You Include in a Buyout Agreement?

Buyout agreements include clauses that define the rights and obligations of the parties involved to ensure a smooth transition. The key clauses include:  

Parties involved

Identify the parties involved in the buyout, including the business, owners, and relevant individuals or entities. This is crucial for establishing who has rights and obligations under the agreement, ensuring clarity. 

Triggering events

Defining the specific occurrences (the use cases mentioned above) that activate the buyout process ensures that all parties understand when the buyout clauses will take effect. A buyout agreement can outline one or multiple triggering events to address various scenarios.

Note: A buyer proposal can also trigger a buyout.

Valuation method

The valuation method states how an owner’s share will be valued when the buyout is triggered. There are many valuation methods; often, a buyout agreement states more than one. 

Three of the most common ones are:

• Book Value: Determines worth using assets minus liabilities, reflecting the business's tangible net worth but excluding intangible assets like goodwill or brand value
• Fair Market Value: Reflects what a willing buyer would pay, factoring in market conditions, intangible assets, and the company’s potential
• Independent Appraisal: Relies on a mutually agreed independent appraiser to value the business or shares during the triggering event

Payment terms and funding mechanism

Clearly stating the funding method in your buyout agreement ensures transparency and allows those taking over to budget effectively or secure funding in advance, preventing the burden of unexpected expenses. Funding methods include life insurance policies, loans, business reserves, or installment payments. 

Restriction on transfer 

This buyout clause allows you to state the individuals or entities not permitted to buy your shares, like competitors or family members. 

It also allows you to give existing owners or the company the right of first refusal, meaning they have the first opportunity to purchase shares before offering them to outside parties. This clause may also require approval from the remaining owners before any transfer can happen, ensuring collective agreement on new ownership. 

Steps to Follow When Drafting a Buyout Agreement

Drafting a buyout agreement goes beyond outlining clauses—it requires a structured process to ensure clarity, fairness, and legal compliance. 

Here’s how you can bring it all together in a few steps: 

1.Evaluate the business structure

Before drafting a buyout agreement, it's important to understand your business's legal structure, whether it’s a partnership, LLC, or corporation. The structure can affect the type of buyout agreement you choose, tax implications, and how you draft it.

For example, partnerships offer more flexibility in structuring buyout agreements, while an LLC may have a stricter process defined by bylaws.

2.Engage with key stakeholders 

Involve stakeholders like business partners, shareholders, and in some cases, family members or investors to  negotiate major clauses like the valuation method, triggering events, payment terms, and any potential business impact whether financially or operationally. This ensures transparency and reduces the likelihood of disputes during or after the buyout process.

3.Conduct risk assessment

A thorough risk assessment helps identify these potential challenges like a drop in market share, cash flow, or asset value that may arise during or after the buyout process. This allows you to adjust the terms of the agreement, such as structuring the payment plan to maintain financial stability or implementing contingency plans like offering incentives to retain key staff.

4.Consult a legal and financial advisor

The complexity of a buyout agreement makes it difficult to ensure a robust and legally compliant contract without professional help. 

Consulting legal counsel is crucial to ensure the agreement aligns with state laws, company bylaws, and other governing laws. Financial advisors or accountants can help structure the buyout in a financially sound and tax-efficient way. A business valuation expert may also be consulted to prevent valuation disputes. 

These professionals ensure the agreement is practical, enforceable, and beneficial to all parties involved.

5.Draft and sign the contract

After finalizing the details, draft the buyout agreement to reflect all agreed-upon terms. Ensure you review the draft thoroughly with all parties to ensure accuracy and clarity. 

Once all parties agree, sign the contract and if necessary, notarize it to improve its legal enforceability. Store the signed agreement securely and review it periodically as the business evolves.

Secure Your Business’s Future With a Well-Planned Buyout Agreement

A buyout agreement is crucial for navigating ownership changes caused by events like retirement, bankruptcy, and death. Defining clauses like triggering events, valuation methods, and funding mechanisms provides a clear framework for smooth, dispute-free transitions.

Beyond mitigating risks, buyout agreements protect your business’s vision, ensuring ownership stays in the right hands. Examples such as Richard Branson’s career pivot and Fuse Media’s post-bankruptcy recovery prove that you need buyout agreements to maintain your business’s stability and ensure growth.

Ultimately, a well-crafted buyout agreement is more than a contingency plan. It’s a strategic investment in your business’s resilience, longevity, and future success.

FAQs

How do company buyouts work?

In a company buyout, one party (e.g., another company, investors, or internal stakeholders) purchases a controlling interest or all of a business. This can involve acquiring shares, assets, or ownership stakes through negotiations, pre-arranged agreements, or legal contracts.

How to negotiate a buyout?

Negotiating a buyout involves valuing the business or shares, agreeing on payment terms, and determining conditions for the transfer. Preparation is key: conduct due diligence, understand market conditions, and consult financial or legal advisors to secure favorable terms.

Who pays for a buyout?

The party initiating the buyout typically pays. This can be an individual buyer, the remaining owners (in cases like cross-purchase buyout agreements), or the company itself (in entity purchase agreements). Funding might come from personal resources, loans, company reserves, or external financing.

What does it mean when a company offers you a buyout?

When a company offers you a buyout, it is proposing to pay you a sum in exchange for relinquishing your shares, ownership stake, or employment. This can occur during restructuring, mergers, or downsizing, with the intent to streamline operations or adjust the ownership structure.