A buy-sell agreement governs what happens to a business when a partner dies, becomes disabled, divorces, or wants to exit. Without one, a sudden departure can destroy a business that took decades to build. Here's what every Michigan business owner needs to know.
What Is a Buy-Sell Agreement?
A buy-sell agreement (also called a business continuation agreement or buyout agreement) is a legally binding contract between business co-owners that governs what happens to a co-owner's interest in the business when a triggering event occurs. Common triggering events include death, permanent disability, divorce, bankruptcy, voluntary departure, or retirement.
Without a buy-sell agreement, a triggering event can create a crisis. If a co-owner dies, their ownership interest may pass to their spouse or children — who may have no interest in, or ability to run, the business. If a co-owner becomes disabled, the remaining partners may be forced to continue paying them while absorbing their workload. If a co-owner wants to exit, there may be no agreed-upon mechanism for valuing and transferring their interest.
The Two Main Structures: Cross-Purchase vs. Entity Redemption
There are two primary structures for buy-sell agreements:
Cross-Purchase Agreement: Each co-owner agrees to purchase the departing owner's interest directly. In a two-owner business, each owner takes out a life insurance policy on the other — so if one owner dies, the surviving owner receives the insurance proceeds and uses them to purchase the deceased owner's interest from their estate. This structure provides a stepped-up cost basis for the surviving owner.
Entity Redemption Agreement (Stock Redemption): The business entity itself agrees to purchase the departing owner's interest. The business takes out life insurance policies on each owner. This structure is simpler to administer in partnerships with many owners but does not provide the stepped-up basis benefit.
For most small Michigan businesses, a cross-purchase agreement is often preferable from a tax standpoint — but the right structure depends on the number of owners, the entity type, and the tax situation of each owner.
Funding: The Most Common Failure Point
A buy-sell agreement is only as good as its funding. The most common reason buy-sell agreements fail in practice is that they are not properly funded — meaning there is no mechanism to actually pay for the buyout when a triggering event occurs.
For death-triggered buyouts, life insurance is the most common and cost-effective funding mechanism. Each owner is insured for an amount equal to the value of their business interest, and the proceeds are used to fund the buyout.
For disability-triggered buyouts, disability buyout insurance provides a lump-sum or installment payment to fund the purchase of a disabled owner's interest. This coverage is often overlooked — but disability is statistically far more likely than premature death for most business owners.
For voluntary departure or retirement, installment payments funded by the business's cash flow are common — but the agreement should specify the terms, interest rate, and security for these payments.
Valuation: The Most Contested Element
How do you determine what a co-owner's interest is worth at the time of a triggering event? This is often the most contentious issue in any buy-sell dispute, and the valuation methodology must be clearly specified in the agreement.
Common valuation methods include:
Fixed Price: The owners agree on a specific dollar value, which must be updated regularly (typically annually) to reflect the business's growth.
Formula-Based: The agreement specifies a formula — such as a multiple of EBITDA or book value — that is applied at the time of the triggering event.
Independent Appraisal: The agreement requires an independent business valuation at the time of the triggering event, with a specified process for resolving disputes between appraisers.
Each method has advantages and disadvantages, and the right choice depends on the nature of the business, the relationship between the owners, and the anticipated growth trajectory.
When to Review and Update Your Agreement
A buy-sell agreement is not a set-it-and-forget-it document. It should be reviewed and updated whenever:
- The business's value has changed significantly - An owner's personal circumstances change (marriage, divorce, health) - A new owner joins the business - The business's entity structure changes - Tax laws change in ways that affect the agreement's structure - Insurance coverage amounts become inadequate relative to the business's value
The Michigan Society for Financial Education covers buy-sell agreements in depth in our 'Business Owner Financial Blueprint Workshop' and our 8-week Business Owner's Financial Mastery Program. Understanding this critical document is one of the most important things a Michigan business owner can do to protect their family and their legacy.