As a business owner, I need to consider a business succession plan. I need to ask myself two questions. Am I going to live forever? Am I going to work forever?
Obviously the answer to both questions is no, so something I need to consider is a buy/sell agreement. The same should go for any business owner. A buy-sell agreement can address the voluntary (retirement) and involuntary (death or disability) transfer of a business from one business owner to another.
Unfortunately these agreements are often overlooked. Similar to the flu shot, most people don’t want to take the time for an unnecessary doctor’s visit when they are healthy. But the moment they get that runny nose and feel the aches and pains, they curse themselves for not planning properly.
I’m here to say a buy-sell agreement is too important to overlook. Whether it’s due to death, disability or divorce (retirement or another break up of business partners), it’s important to develop a business transition plan. You took the time and energy to build a great business; why not make sure you have a game plan to exit it as well?
Why do You Need a Buy-Sell?
At some point, you are going to leave your business. Whether you choose to (retirement) or not (because you die) is not always up to you. A buy-sell agreement can address who gets the business, how it’s valued, and how it’s paid for. One step further, it will be signed and agreed to by the key people you want involved in the transaction.
A strong agreement avoids leaving your intentions unclear; instead it will provide the who, what, where, how, and when the agreement should be completed.
You want your buy-sell agreement to address a number of issues. I am going to use my current work situation as an example:
- Transfer ownership of the business – I am in business with my dad. If he is to die, my mom will inherit his shares of the business. A buy-sell agreement may legally require me to buy those shares from my mom (and bind her to sell). This is ideal because my mom would prefer the value of the business, not the actual shares. And surprise surprise, I would want the shares.
- Create Liquidity – Now that I am to be legally bound to buy my dad’s shares of the business, I need money. However, I don’t have that kind of money lying around. So where does it come from? Answer-Life insurance. Written into the agreement, I may be required to purchase a life insurance policy on my dad. If he is to die, I will receive the life insurance proceeds. Upon receipt, I can use that money to buy the shares from my mom.
- Peg the Value – How much would I owe my mom? A good buy-sell agreement will include a formula for valuing the business. There are number of ways to determine the fair market value of a business, and a good place to start could be a qualified appraiser or your accountant.
How do You Fund a Buy-Sell?
- Self Insure – Self insuring a buy-sell agreement is the do nothing method for funding agreements. It means the business owners will assume the risks associated with the death, disability, or divorce of the business partners. Upon one of these events, the business owners will “come up with” the necessary cash for the buyout. The funds for the buyout may come from cash on hand, earn-out from revenue, or a loan from the bank.
- Life Insurance – Life insurance is a common strategy used by business owners to create liquidity that can fund a buy sell agreement. Life insurance will provide immediate liquidity (the value of the death benefit) to the remaining business owners should one of them die. Depending on the type of life insurance used (term or permanent), life insurance may also accumulate cash value that can be used to fund other buyout needs such as disability or divorce.
What are the Types of Buy-Sell Agreements?
- Cross Purchase Agreement – With a cross purchase agreement, each business owner owns an insurance policy on the other partner(s) of a business. They name themselves as beneficiaries. What does this mean? If one partner dies, the other partner receives the death benefit. They in turn use this money to buy the shares of the business from the deceased partner’s spouse or appropriate beneficiary. The surviving partner then owns all the shares and takes control of the company, and in return the beneficiary of the deceased has a cash payout.
- Entity Purchase Agreement – With an entity purchase, the business itself owns and is named the beneficiary of an insurance policy. If one of the partners dies, the life insurance benefit is received by the company. The company uses the cash to buy out the deceased partners shares from his/her estate.
So you ask….Which is the Best Option?
Like a lot in the financial industry there is not a 100% absolute answer. As a business owner you need to look at all the moving parts that keep your business running smoothly and account for them in your buy-sell agreement. Your main goal in creating the agreement is to provide certainty. What is best for each business depends on the business value, the number of partners, and individual goals and objectives.