Clients often ask me what documents they need to have in place when starting a business relationship. While the answer depends, of course, on the circumstances, one document essential to privately held companies is often overlooked: the Buy/Sale Agreement.

Actually, the Buy/Sale Agreement is important in two contexts: as part of the formation of the business relationship and as part of succession planning. This article addresses the former; the next, Part II, will address succession planning.

A Buy/Sale Agreement is an agreement among business owners regarding the disposition of their respective business interests. It can be a stand-alone agreement or part of another agreement, such as a shareholders' agreement. Since the best time to decide how to end a business relationship is at the beginning of that relationship, not at the end, the terms of a Buy/Sale Agreement should be decided when the relationship is formed.

A Buy/Sale Agreement enables the business owners to make decisions, not the circumstances. A good Buy/Sale Agreement will cover issues that invariably lead to problems if left unaddressed. It will address tough issues such as the sale of an owner's interest in the business and the value of the business, as well as provide a framework for resolving disputes among co-owners.

Buyout

A Buy/Sale Agreement handles the question of how an owner's interest can be sold, pledged, or encumbered. Suppose you and Jan own a small web design business. Each of you works in the business, providing your own unique expertise. Jan is the web design guru.

One day, Jan tells you she is selling her interest in the company to Patty. Patty may be a marvelous person, but, like me, may know nothing about web design. In all likelihood, you would prefer that Jan sell to someone who can also work in the business, or better yet, that she sell her interest to you.

That's where a Buy/Sale Agreement comes into play. If you have one in place, it determines who can buy an interest in the business. Without the agreement, Jan is free to sell her interest to anyone, and you will be in business with that new person.

A Buy/Sale Agreement also addresses other events such as the death, incapacity, or divorce of a business owner. Suppose Jan dies. Her interest in the business will go to her heirs, her children, Sally Irresponsible and Tommy Workless. Without a Buy/Sale Agreement in place, you could find yourself in business with Sally and Tommy, or having to muster the money to buy out their interests.

Furthermore, if Jan divorces, her interest in the business may be marital property. If Jan becomes disabled, you may need to replace her. However, without a Buy/Sale Agreement, you cannot compel a sell. Also, just suppose that you no longer want to have Jan as a co-owner: a properly written Buy/Sale Agreement will specify the steps for the buyout.

Value

In addition to laying out the rules for the sale of an owner's interest, a Buy/Sale Agreement handles the question of how to value a business. Privately held businesses are not always easy to value. The best time to determine the value is while you and your co-owners are alive and healthy, and have no conflicts. A Buy/Sale Agreement may establish a mechanism or formula for valuing your business. Doing this will avoid many, many painful moments in the future.

One of the bigger fights among business owners or their heirs seeking to buy out another owner is over the worth of the business. Yet, with a good Buy/Sale Agreement, this problem can be easily avoided.

If all else fails, and you and your co-owner are in dispute, a Buy/Sale Agreement will provide a framework for resolving the dispute. It may require binding arbitration. It may set up a process for resolving disagreements over valuing the business. In any event, it is much better for you and your co-owner to have in place a dispute resolution process before any disputes arise.

As you can see, a Buy/Sale Agreement is an essential part of the formation of any business relationship. Next month, we will look at the role a Buy/Sale Agreement plays in succession planning.