Whether starting a new company, planning for succession, or managing ownership transfers, a buy-sell agreement is a key legal instrument. Every business owner should understand how the agreement operates, as it is a fundamental component of business law that protects the interests of both the company and its stakeholders. At Strategy Law, we provide businesses and their owners with legal guidance based on knowledge that has been refined over decades to help them develop agreement terms that are tailored to best serve the unique needs of each owner, while protecting the overarching goals of the company. This article will outline the key elements of a buy-sell agreement, and explain why a well-drafted buy-sell agreement is crucial to your company’s long-term success.

What is a buy-sell agreement?

A buy-sell agreement is a legally binding contract between shareholders or business partners that specifies how a company will be purchased or sold under particular conditions. These contracts are most frequently utilized in closely held businesses or partnerships, where ownership continuity is essential to the smooth functioning and financial standing of the company.

In virtually all circumstances, company founders come together with the intention to build a company that will endure the test of time. However, plans change. There is no shortage of situations where the endurance of the company no longer aligns with the direction of an owner for various reasons. A well-drafted buy-sell agreement guarantees that the remaining owners can buy the leaving owner’s share of ownership interests in the case of such leaving owner’s retirement, incapacity, death, or even a voluntary resignation. Additionally, the buy-sell agreement can protect the interests of the leaving owner, by establishing preset means of evaluating their ownership, and also prevents outsiders from taking over the company.

Why do you need a buy-sell agreement?

In the early stages of the formation of a business, a buy-sell agreement is often overlooked, but failing to have one can lead to significant problems later. Here are some reasons why business owners in San Jose should prioritize creating a buy-sell agreement:

1. Smooth transition of ownership:

A buy-sell agreement offers a transparent and clear ownership transfer procedure. Many times, ownership interests must transfer due to significant life events, such as death, incapacity, or divorce. The clarity provided by a well-drafted buy-sell agreement helps investors, heirs, or business partners avoid disputes by creating a fair and understandable process by which ownership interests transfer. Without this contract, the transfer procedure may be costly and fraught with legal complications extending over months (or even years), and the end result could very well be disruptive to the company’s operations.

2. Protects the business’s value:

By setting clear conditions for the purchase or sale of an owner’s shares, preemptively establishing company valuation methods, and identifying ways in which a company can supplement the loss of a key owner, a buy-sell agreement guarantees that the business’s value is safeguarded and that its operations can proceed unbroken. This is particularly important for closely owned companies in San Jose, as the loss of a significant partner may affect the company’s operational and financial health.

3. Prevents unwanted third-party ownership:

Prohibitions and strict limitations on transferring ownership to third parties is a fundamental component of most buy-sell agreements. In addition to maintaining the company’s culture and preventing outsiders from gaining access to confidential company data or influencing decision-making, this guarantees that the remaining partners maintain control over who they collaborate with.

4. Ensures fair valuation of the business:

Buy-sell agreements frequently contain clauses that specify how much the company will be worth after a transaction. This valuation may be determined by a third-party valuation expert, an appraisal, or a predetermined formula. This clause in the contract gives everyone a chance to consider how a fair valuation should be determined on an objective basis early on, rather than at a point when they may be more inclined to engage in disputes with the other owners.

5. Addresses funding mechanisms:

In the event of a buyout, a well-written buy-sell agreement specifies the financing method for the acquisition. Whether through the company’s cash savings, loans between the seller and the compnay, or insurance, such as “key man insurance” or “key person insurance”, having a well-defined plan guarantees that the company has the resources needed to complete a buyout.

Types of buy-sell agreements

There are several types of buy-sell agreements, each suited to different business needs and structures. Here are the main types of buy-sell agreements:

1. Cross-Purchase Agreement: In the cross-purchase structure, when there is an event that triggers a right or obligation to buy out another owner’s shares, such as a partner’s resignation, the remaining partners have the right to buy the resigning partner’s ownership interest. Each such remaining partner can purchase a proportionate stake from the leaving partner. Businesses with a small number of partners, where each partner can afford to buy out the others, are best suited for this kind of arrangement.
2. Entity-Purchase Agreement: In the entity-purchase structure, the company (the entity), rather than the other individual owners, has the right or obligation to buy back the departing owner’s shares when a triggering event occurs. Put another way, since the transaction is between the company and the departing owner, payment for the departing owner’s interest comes from the company’s bank account, rather than the individual accounts of the other owners. Since the company is in charge of the buyout, this strategy is more common in companies with more than two partners and is frequently thought to be simpler for the remaining partners to handle.
3. Hybrid Agreement: In a hybrid buy-sell agreement, aspects of the entity-purchase and cross-purchase models are combined, such that both the company and the other owners can have an opportunity to buy out the departing ownership shares. The opportunity to do so can be structured in any order; The right to buyout can be an option held by the company first, and then pass to other owners thereafter, or it can be the reverse—the other owners can have the first bite at the apple, before the option to purchase passes to the company. By permitting the purchase of shares of a departing owner by both the remaining partners on the one hand, and the company on the other, and allowing for an ordering of priority, this structure offers flexibility.

How Strategy Law can help

At Strategy Law, we understand how crucial buy-sell agreements are for maintaining the continuity and stability of your business. Our experienced and proven business law attorneys will collaborate with you to consider your company’s financial realities, prospective risks, and specific business needs. Using our vast breadth of experience and specialized expertise, we can help draft a tailored buy-sell agreement that protects your company, manages potential ownership changes, and ensures a smooth transition. 

By partnering with Strategy Law LLP, you can ensure that your buy-sell agreement is comprehensive, legally sound, and aligned with your business goals. To arrange a consultation with one of our knowledgeable lawyers, contact us right now.

This blog is written as of February 2025.  Recommendations and legal requirements are changing rapidly, so please continue to review our legal updates or review postings on relevant government websites.

All blogs on this site are for educational purposes only, do not constitute legal advice or opinion, and should not be applied to your situation, or any specific situation, without consultation with counsel. Strategy Law, LLP does not provide any legal advice concerning any matter discussed in a blog except upon formal engagement including, without limitation, execution of Strategy Law, LLP’s formal legal services agreement, and with respect to specific factual situations.  No blog constitutes a guaranty, warranty, or prediction regarding the result of any legal matter discussed in the blog or any representation.