Plan for the unexpected. Protect your business.
If you co-own your business, a buy-sell agreement could end up saving you considerable time, money and headaches in the aftermath of an owner exit.
Essentially a contract legally defining the process of a partner leaving a business, a buy-sell agreement outlines terms and conditions governing the transfer of a deceased or exiting owner’s stake. If this exit happens because an owner dies unexpectedly, a life insurance policy can help the remaining owners fund the purchase of their ownership interest.
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Typically focused on how the exiting member’s shares will be sold, a buy-sell agreement names beneficiaries, establishes an agreement on fair market price and outlines the protocol for transferring ownership interest.
While drafting a contract is a great start, a buy-sell agreement is effectively worthless without a means to fund a buyout.
What if a co-owner dies, becomes disabled or suddenly wants to leave a business, and you and your remaining partners don’t have enough cash on hand to cover the purchase of your ownership interest? Fortunately, with a life insurance funded buy-sell agreement in place, you may not have to worry.
Funding buy-sell arrangements with life insurance policies can offer a simple, cost-effective way to manage the unexpected death or departure of an owner.
During the time we’ve partnered with Higginbotham, they’ve been very good about adjusting to us and our needs and making us aware of any kind of insurance we might need. They are proactive and we don’t have to ask.
If you’re new to buy-sell agreements, you may have some questions.
Whether you’re just getting started or need more information to help guide your decision, these insights were written with you in mind.
Keep reading to learn how a buy-sell agreement works, strategies you can use to fund a buyout and how insurance can help serve as a solution to some of the more common issues you may face.
If you’re interested in forming a buy-sell agreement, but aren’t sure where to start, these questions can help guide your planning process:
While answering these questions is a great start, you should conduct a formal business valuation before drafting a purchase agreement.
Once you have a clear understanding of the value of each owner’s stake, you’ll need to come to an agreement on post-exit options for the remaining owners.
If one of these options involves purchasing the deceased owner’s shares, you’ll then need to decide how to fund that purchase.
There are several available funding options to consider for those in the planning stages of a business exit strategy.
Perhaps the most straightforward way to fund a buyout, a cash purchase of a co-owner’s stake in a business tends to be much less complicated than the other available funding strategies.
That said, the ability to pursue a cash buyout is contingent on the remaining owners having adequate cash reserves to fund the purchase. While partners in a smaller, mature business may have the cash on hand to buy a co-owner’s shares, new businesses and large enterprise organizations may not have that kind of capital in a cash account.
Whether capital is tied up in inventory, illiquid assets or investments, many organizations simply cannot afford an unexpected cash buyout.
If you’re planning an exit strategy and want to avoid paying interest on a loan, a sinking fund may be an excellent avenue for you to explore.
Like the cash buyout strategy, this option leverages capital on hand to fund the purchase of an exiting owner’s shares.
Especially useful for mature businesses with high dollar ownership stakes, a sinking fund functions much in the same way as a traditional savings account, with money set aside each month to help fund a future purchase.
Though a sinking fund can be a great mechanism for funding a buyout, it has one glaring downside: if a partner unexpectedly passes away, becomes disabled or wants to exit the business without much notice, there may not be enough value accrued in an account to cover the purchase.
If you and the other business owners find yourself in this situation, a loan may be your best course of action.
While interest payments can make this option less than ideal, the additional cost typically pales in comparison to the alternative of not having enough money to fund a buyout.
For those wanting to avoid the risks of a sinking fund and the added cost of a loan, a seller-financed buyout with installment payments could be another viable option to consider.
That said, this strategy is contingent on the seller being agreeable to a longer-term payout and may not be feasible in some situations.
Along with offering cost savings over a lump sum cash payment, insurance policy funding also helps avoid the interest of a loan. Funding a buy-sell agreement with life insurance can also help make sure the business will have the means to purchase an exiting owner’s shares, regardless of timing.
As a bonus, if a partner passes away shortly after an agreement is drafted, the total premium paid to date will be much less than the death benefit received.
Even if a partner exits voluntarily, insurance can still help with a buyout. This is achieved by drawing or borrowing against the policy cash value that accrues over time. In most cases, supplementary disability coverage can be added to cover the possibility of an unexpected owner disability forcing a buyout.
There are several ways to structure a life insurance funded buy-sell agreement.
If you have ownership interest in an LLC with two or more additional owners, you can opt to draft a buy-sell agreement in which a partner exit triggers the formation of a new LLC.
This buyout strategy is typically funded by a life insurance policy on each partner purchased by the business. If a partner passes away, the ownership interest is split between the remaining owners, with the death benefit payment from the policy used to compensate heirs.
Because shares are transferred using a step-up in basis, this approach can help the surviving partners avoid tax liability.
Like the LLC option, a stock redemption buy-sell agreement facilitates the transfer of a deceased partner’s ownership interest to surviving partners.
While these buy-sell agreements are quite similar, a stock redemption agreement is more appropriate for organizations that issue shares of stock. When an owner dies, the death benefit from the company-owned life policy is used to fund the purchase of the owner’s shares, with the business retaining the shares and the owner’s estate receiving a cash payment.
A cross-purchase exit arrangement also uses insurance policies to fund the purchase of ownership interest in the event of a partner’s death.
These agreements work by first purchasing life insurance policies for each business owner, with the other owner(s) named the beneficiary. If a partner passes away, the surviving owners receive a death benefit to use toward purchasing the deceased owner’s stake in the business.
Cross-purchase arrangements also offer a tax benefit by way of a step-up basis ownership transfer.
If you and your family rely on your business to cover living expenses, you need an exit strategy. Even if your spouse has a separate income or you have no dependents, a buy-sell agreement can be a good idea. The last thing you want is for your partner’s sudden departure to put your business in jeopardy or leave it in the hands of an unqualified owner.
Transferring ownership interests without a formal arrangement in place is not only complicated, it can also be detrimental. From unfulfilled contracts to an unexpected loss of revenue, a poorly executed departure is a headache you’d be better off without.
Regardless of the circumstances surrounding your situation, a life insurance-funded buy-sell agreement can be a great way to help ensure business continuity in the aftermath of an owner’s exit.