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IF YOU RUN YOUR SMALL BUSINESS with a partner or partners, you surely hope that your relationship remains intact forever. But admit it: You've lost sleep worrying about what would happen should one of you decide to back out for some reason or even die. Depressing? Yes. But you'd be foolish not to consider the implications.

The solution to this concern is to craft what's known as a "buy-sell agreement." A good one helps do the following:

• Turn your business ownership interest into a more liquid asset. (Closely held business ownerships are notoriously difficult to sell to outsiders.)
• Prevent unwanted ownership changes. (You don't want to have to deal with new co-owners who you had no part in choosing when the existing ownership group starts to turn over, as it inevitably will.)
• Possibly save estate taxes and definitely avoid unnecessary hassles between your heirs and the IRS about what your ownership interest is worth when you leave this cruel orb. (Disputes over valuing closely held business ownership interests for federal estate tax purposes have kept lots of high-dollar lawyers and CPAs busy for decades.)

Herewith, the basics of the buy-sell agreement. After you've read them, print yourself a copy of this article and huddle with your co-owners, attorney and tax pro to hash out a buy-sell agreement that suits your situation.

The Fundamentals

Buy-sell agreements are a type of business contract. They come in two basic flavors: cross-purchase agreements and redemption agreements (sometimes called liquidation agreements).

A cross-purchase agreement is a contract between you and the other co-owners whereby you as a group agree to buy out an exiting co-owner's ownership interest when and if a triggering event (such as death or disability) occurs. This arrangement will benefit you or your heirs when it's your turn to withdraw.

A redemption agreement is a contract between the legal entity used to conduct your business operations (usually a partnership, limited liability company (LLC), or corporation) and the entity's co-owners. Under this type of agreement, an exiting co-owner's ownership interest must be purchased by the entity itself (as opposed to the remaining co-owners) when and if a triggering event occurs. Once again, this benefits you when it's your time to pull out.

Both cross-purchase and redemption agreements have the following main goals in common.

1. Ensure there will be a willing buyer for each co-owner's interest when a triggering event occurs.

2. Restrict each co-owner from unilaterally transferring his or her ownership interest to someone outside the existing ownership group.

3. Ensure favorable tax results for all concerned.

Triggering Events

In your buy-sell agreement, you and the other co-owners must specify the triggering events you want included in your deal. Death, disability and a stated retirement age are almost always listed. You are free to come up with other triggers that make sense in light of the nature of your business and the co-owners' personal situations. Other appropriate triggering events could include a co-owner's loss of his or her professional license, bankruptcy, divorce (especially in community property states where both spouses are generally deemed to own everything 50/50), or the simple desire to cash out of the business and move on to other things.

Valuation and Payment Terms

Next, make sure your buy-sell agreement stipulates a mutually acceptable method for valuing ownership interests when triggering events occur. The three most common methods are a price based on a fixed per-share figure (updated periodically); a price based on fair market value as determined by professional appraisal; and a formula price based on a multiple of annual earnings or cash flow (such as: the formula price equals seven times annual cash flow times the percentage ownership interest in question).

It's very important to establish a pricing method that the IRS will respect for federal estate tax valuation purposes (more on that later).

Also, make sure your buy-sell agreement states how amounts will be paid out to withdrawing co-owners or their heirs under the various triggering events (for example, a lump-sum payment if the co-owner dies, or equal installments over, say, five years plus interest for other triggering events).