Advice for entrepreneurs seeking to partner with talented, like-minded people in an effort to develop and manage a business: follow the exit lights. Whether you’re about to start a business, or have been operating one for years, it’s imperative you adopt a buyout agreement.

Reasons you may have neglected to do so, thus far:

• “My partner(s) and I always act in each other’s best interest.”
• “We plan for success, not demise.”
• “We’ll cross that bridge when we get there.”
• “It’s an awkward conversation.”
• “We are a family business.”
• “We’ve discussed it, and don’t need to put it in writing.”

And the list goes on and on. In so many ways, it is awkward to discuss the dissolution of your firm, or the departure of an owner – whether by convenience, disablement or death. It’s like asking your fiance for a prenuptial agreement; requesting a “Do Not Resuscitate” order; or planning your own funeral. It can be downright awkward.

So, if you think you’ve got it all figured out, what happens when, let’s say:

• You’ve agreed on a buyout price for your ownership interest, but because of cash flow issues, there is simply no money available at the time of your departure?
• It’s time for you to move on, but your partner refuses to buy out your shares; you can’t find an outside buyer willing to purchase a minority interest; and you’re left with a worthless piece of paper?
• An owner sells her interest to an outside buyer, or gives her interest to her son, and the new owner is not qualified to manage the business?
• An owner divorces, and the courts grant her ex-husband – whom neither of you can tolerate – 50% of her ownership interest?
• An owner loses a professional license, which impedes her ability to generate revenue for the business?
• A partner becomes mentally incapacitated or otherwise disabled, and endangers the reputation of your business?
• You die, and your significant other is left with an ownership interest in a firm he does not wish to manage?

Once again, the list goes on and on. The most fundamental factor that will harm you, your partners, and your business, is emotion. If you think it’s stressful managing your business now, wait until your partner decides it’s time to move on, and you can’t help but feeling abandoned. Or wait until your partner and life-long friend dies, and her family demands fair market value for her shares, which you know will shut down your business.

If you’re rolling your eyes at my “what if?” list, be certain of one thing: there will be a “what if?” scenario. And at the time of that scenario, there will be emotions involved that may cloud your judgement, harm your interests, and result in costly consequences both psychologically and fiscally. It’s imperative you plan your buyout agreement while emotions are even-keeled, and you can objectively agree on an exit strategy that is mutually beneficial to the departing owner, the remaining owners, and the company in general.

So, what are some common provisions in a buyout agreement? Well first, it’s important to note that provisions may be tailored to offer greater benefit to either the majority or the minority owner. Therefore, in order to achieve a mutually beneficial agreement, it’s important to understand the advantages and disadvantages of each provision both from the perspective of a majority owner and minority owner. In fact, provisions in the agreement may include exceptions that could apply to majority owners, but not to minority owners. Bottom line, if you’re a minority shareholder, I advise you are very cognizant of any contractual language that may place the majority owners at a distinct advantage.

Below, I’ve listed a few basic examples of buyout agreement provisions:

Right of First Refusal

Wisely, this provision offers the company and continuing owners the first option to purchase a departing owner’s interest. If declined, the departing owner can sell her interest to an outside party, potentially at fair market value. Since, the company has the right to purchase the interest, the continuing owners can prevent the entrance of a new owner who may be a complete stranger, or may not even be qualified to manage the business. For the departing owner, the ability to “shop” the interest to an outside buyer may result in a higher buyout price for the interest. While this is a nice provision, a departing owner may have difficulty selling her interest to an outside buyer – the likelihood that an outside buyer will pay fair market value for a minority interest in a small business is next-to-nil. In result, the departing owner will be forced to sell her share back to the company or continuing owners at an unfairly discounted value.

Right to Force a Sale

As an extension/alternative to the Right of First Refusal, the Right to Force a Sale offers distinct benefits to the parties. First, let’s identify a small business owner’s primary source of income: salary, benefits, and other expense-related perks. If you are a departing owner with no potential buyers, what’s the value of your interest? Remember, you likely no longer collect a salary, receive benefits, or earn performance-related incentives. What about your small cut of the profits? Yes, but let’s be realistic; the company will find ways to cut you out of the mix. After all, you’re not even participating in the business anymore, so, why should they feel obligated to pay you anything?

Bottom line, when you leave your business, you’ll want to get paid. And that’s why you, as a potential departing owner, should include the Right to Force a Sale. With this provision in place, a departing owner must simply provide an Intent to Force a Sale Notice, which will trigger the company or continuing owners to purchase the interest at the value determined in the buyout agreement. And remember, this also benefits the company and continuing owners because it ensures that the ownership interest is not transferred to a new person who may not have the credentials, management skills, or interpersonal skills necessary to functionally operate the business. Moreover, at the inception of the buyout agreement, the owners may likely agree on a more favorable buyout price and payment terms for the company or continuing owners, because the departing owner is guaranteed the sale.

Next, you must determine who will be responsible for buying a departing owner’s interest. You may either (A) execute an entity purchase buyback, which obligates the company to purchase the departing owner's interest, and then distributes the newly acquired interest proportionately to the continuing owners, or (B) execute a cross-purchase buyback, which may offer any of the continuing owners the option to purchase the departing owner’s interest.

What about the value of your business? Clearly, you aren’t publicly traded. So, how do you even know what your business is worth? The most simple yet severely flawed method is the Fixed Price Method. This method does not take into account profitability; goodwill, such as reputation and customer retention; or any other factor. Generally speaking, it’s unfair to any party involved. On the other end of the spectrum, you can pay to have your business professionally appraised, but a proper appraisal may cost in excess of $10,000. In consideration of both extremes, the Capitalization of Earnings Method offers a fair and widely adopted valuation formula, specifically the EBITDA formula – Earnings Before Interest Taxes Depreciation and Amortization. Since it’s a valuation formula, the buyout price will be the product of the successes and failures of the company, offering the departing owner a more realistic, representative buyout price at the time of her departure.

For owners of small businesses, cash flow is typically the biggest concern. So, when a departing owner is ready to leave, becomes disabled, or dies, how do you plan on funding the buyout? From insurance policies to tax implications, you’ll have to research numerous considerations specific to your type of organization, whether it’s a partnership, LLC, or corporation.

Once you determine how to fund it, you’ll have to agree on payment terms. Since, you have no way of knowing when an owner may leave the business, or even more, what your cash flow will be at the time of the departure, you should avoid offering a lump sum payment. Instead, offer installment payments over a period of one to three years. And while you will pay interest on these installments, the ability to make more palatable payments over a period of years may be the key to keeping your business afloat.

In conclusion, now is the time to start a conversation with your current or future partners. And while, in any case, you should consult an attorney before executing any agreements, I strongly recommend you read "Business Buyout Agreements," written by Attorneys Bethany Laurence and Anthony Mancuso. For those of you unfamiliar, NOLO is a publisher that offers great resources for a wide variety of legal matters. In fact, this book actually includes a print and digital copy of a sample buyout agreement, helping you tailor it to your needs, step-by-step. Proper research will allow you to do the majority of the leg work on your own, and more importantly, in collaboration with your partners. Just remember, it's a whole lot easier to create this agreement now, so get started!