What is a redemption agreement?

When individuals start a business with friends or family members, those individuals often focus mainly on getting the necessary documents in place to create and run the business in normal times. Such documents include state-required Articles of Organization to form a Limited Liability Company (LLC) or a Certificate of Limited Partnership to form a Limited Partnership (LP). In addition, individuals may document a partnership or operating agreements, which define how the business operates and the day-to-day roles and responsibilities of each business owner.

However, individuals often neglect to define what will happen when a member or owner of a business departs from the business. Who will purchase the departing owner's interest in the business? How much will they pay for that business interest? In such cases, those individuals need a buy-sell agreement.

The purpose of this article is to provide an overview of buy-sell agreements, including the purpose and types of buy-sell agreements.

Purpose of a Buy-Sell Agreement

A buy-sell agreement defines what will happen when a member of the business wants or needs to leave the business. The buy-sell agreement fulfills this role by defining the buyout terms to purchase the departing individual's interest in the business. Although a buy-sell agreement may be a component of a partnership or operating agreement, such agreements do not always language to address the buy-sell topic.

A buy-sell agreement typically goes into effect when a defined triggering event takes place. A triggering event can include one or more elective or unavoidable situations. Examples of triggering events include but may not be limited to a business member simply wanting to leave a business to focus on other activities or retire, a business member needing to leave the business because he or she can no longer perform his or her responsibilities for health reasons, or even the death of a business member.

The advantage of a buy-sell agreement is that, by defining the buyout terms up front that an individual receives when he or she leaves the business, the agreement allows a business to continue to run smoothly rather than face the distractions and possibly difficulties involved in negotiating buyout terms. This is especially true in the event the departure of a business member is not an amicable one.

A buy-sell agreement usually establishes the funding source for the buyout. Funding of the purchase may include a lump sum or installment payments made from the savings of the business. In the event of the death of a business member, funding may come from a life insurance policy held by the business on the member.

It is worth noting that a buy-sell agreement may bring with it several pitfalls worth considering. Depending on the nature of the business and the speed with which the business grows, it may be difficult to define up front the buyout terms or value for the share of a business member. In addition, the business may not be capable of maintaining adequate funds to fulfill the terms of the buy-sell agreement upon the triggering event.

Finally, the agreement may limit the flexibility the remaining owners have in allowing the family of the departing business owner to step into the role formerly held by the departing member.

Types of Buy-Sell Agreements

There are three common types of buy-sell agreements.

1. Cross-Purchase Agreement – A cross-purchase agreement is one in which all of the other business owners buy the interest of the departing business member for a defined price.
2. Redemption Agreement – A redemption agreement is one in which the business itself buys the interest of the departing business member for a defined price.
3. Hybrid Agreement – A hybrid agreement is one in which the remaining business members have the option to buy the business interest of the departing business member for a defined price. In the event the remaining business owners do not want to or cannot afford to buy the business interest of the departing business member, the business itself buys the interest of the departing business member for a defined price.

Each type of buy-sell agreement may have mandatory and optional components defined in the agreement.