Business owners know that proper planning is critical to the growth and success of businesses of all sizes. However, many business owners neglect to consider that their business’ continued success is also dependent on proper planning in the case of a “triggering event” such as retirement, divorce, disability, or death of a key owner. Many difficult questions need to be answered to ensure a smooth and successful transition of ownership. As a business owner here are a few of the key questions to consider:
- Who will run the operations of the business?
- How will the ownership structure change?
- How will my family be provided for?
- Is there debt associated with the business?
- Can/will family members of the deceased/disabled owner become involved?
- How will the remaining owners finance any buyout of the deceased owner’s share?
If you run a business in which you have invested considerable time and money or from which you earn your living, a buy-sell agreement should be considered as a means of protecting your business assets. A buy-sell agreement can benefit businesses of all shapes and sizes including sole proprietorships, partnerships, S corporations, C-corporations, and Limited Liability Companies.
A well thought out and properly implemented buy-sell agreement will ensure an orderly transfer of the business if/when a key owner retires, divorces, becomes disabled, or dies. When you set out on creating a buy-sell agreement you should have a few goals in mind:
- Create a market for the business’ stock when it is needed
- Establishing the value of the business today
- Establish a methodology for the business’ future valuation
- Create the funds needed to buy out an owner’s share
- Create the funds needed to pay estate tax and estate settlement costs
- Establish the framework for the transfer of ownership
- Reduce the overall risk to the business
How A Buy-Sell Works
A well thought out and implemented buy-sell agreement anticipates potential changes to a business’ future valuation and provides the mechanisms for a successful business transition. There are five main types of buy sell agreements and each functions differently in practice:
- Entity Purchase or Stock Redemption Agreement: the business will purchase the owner’s share in the case of a triggering event.
- Cross Purchase Agreement: in the case of a triggering event the remaining business owner(s) purchase the other owner’s shares directly.
- Trusteed Cross Purchase Agreement: also known as an “Escrowed Buy-Sell”. An independent trustee holds the stock certificates of each owner. In the case of a triggering event the trustee then manages the purchase, payment, and re-allocation of shares on behalf of the owners.
- Wait and See Buy-Sell Agreement: provides flexibility in determining the type of buy-sell agreement to use at the time of the triggering event. Typically the two options made available are a Cross Purchase or Entity Purchase agreements. The business usually has the first option to purchase the available stock via an Entity Purchase Agreement. If the business opts not to purchase the available stock, the remaining owner(s) then have the option to purchase the available stock via the Cross Purchase agreement.
- No-Sell Buy-Sell Agreement: allows for the transfer of all voting interest to the remaining owners in the case of a triggering event. However, this leaves the non-voting interest with the exiting owner and/or its heirs. This type of agreement is useful for businesses that anticipate substantial business valuation appreciation and would like to share the potential gains with the exiting owner or their heirs.
Utilizing Life Insurance to Fund a Buy-Sell Agreement
Life Insurance is often deemed to be one the most affordable and effective methods of funding a buy-sell agreement for the following reasons:
- Cash is made available in the event of death for the business or surviving owners to purchase the deceased owner’s shares. This reduces or eliminates the potential financial burden of purchasing a large portion of stock to the business or surviving owners.
- Proceeds from Life Insurance enjoy favorable tax treatment
- Cash accumulation values from a policy (if the policy provides an accumulation account) can be used to help fund the purchase of stock in the event of disability, divorce, or retirement.
- Life insurance premiums can be very affordable relative to the other options for funding a buy-sell agreement which include (accessing the working capital of the business, borrowing funds from a third party , or creating a sinking/savings fund) to provide the funds the execute a smooth business transfer.
Given the broad range of planning options available to business owners, we recommended that all business owners conduct a buy-sell analysis to identify the needs and goals unique to their business. This will allow your team of advisors to present the options that best meet the needs of your business. Contact us for additional information and to receive our free Buy-Sell Agreement Analysis kit.