A fundamental part of any go-to-market plan for owners of a new business venture is the buy-sell agreement: a contract that offers them a method by which to gracefully exit the business or resolve disputes on mutually acceptable terms. Yet, say advisors interviewed by National Underwriter, few other business documents contain as many minefields.

“In almost any other negotiation, you know which side of the table you’re on,” says John Freiburger, a certified financial planner and principal of Partners Wealth Management, Naperville, Ill. “But when it comes to buy-sell agreements, you don’t know whether you’re negotiating for yourself or against yourself.”

The reason, he adds, is that several “triggering events” have to be factored into the buy-sell contract, any one of which can upend even the most successful business without careful consideration of its impact. Among them: the death, disability, divorce or retirement of one or more of the firm’s principals; or a forced departure because of disagreement among company owners.

Also key is how the buy-sell agreement will finance the buy-out of a departed principal’s interest in the firm. Generally, life insurance will serve as the chief funding vehicle, but in which situations would a particular life insurance contract be best? And how large should the policy’s face amount be?

The answers to these questions, sources say, will depend much on the owners’ corporate and personal planning objectives, their ability to fund out of cash flow, how the business is structured and valued upon the triggering event, and how payments to departing owners or their survivors will be made (i.e., as a lump sum and/or in installments).

Even a well-designed buy-sell can prove useless if it isn’t properly executed. Sandra Bring Heusinkveld, a chief life underwriter for Financial Planning Perspectives, Columbus, Ohio, says many doctors and lawyers are prone to giving away controlling interests in their practices as they add new partners. As a financial inducement to the new partners to join their companies, this strategy may be effective, but it ultimately could prove detrimental to the original owners.

“Once they give up control, these professionals leave themselves with little room to negotiate when it comes time to exit their practices,” says Heusinkveld. “The buy-sell is rendered unenforceable by virtue of what they’ve done. This speaks to the importance of keeping a team of advisors involved and working together.”

Problems respecting implementation are less likely to arise, she adds, if the buy-sell is framed from the get-go to account for all contingencies. For advisors, a key issue concerns the type of contract under which the business should operate. Often, the choice will be between 2 types: entity purchase (or stock-redemption) agreement; and the cross-purchase agreement.

In the first type, the business purchases (or redeems) the interest of a departing owner. After redemption, the ownership percentage of each of the remaining owners increases (e.g., from 25% to 33% in cases where the number of owners declines from 4 to 3.). Under a cross-purchase deal, the remaining co-owners buy out the interest of the deceased or departing owner.

How to decide between these contracts? A key consideration is the number of owners in the business. Advisors say they favor a cross-purchase agreement where there are only 2 or 3 owners, in part because of the “step-up in basis” that kicks in upon the death of a principal, the rule eliminating any taxable gain that remaining owners would otherwise be liable to pay. Cross-purchase agreements also generally receive more favorable treatment than do entity purchase agreements under IRC provisions respecting family attribution rules and the alternative minimum tax.

“Everything being equal, there are greater benefits for a client in a cross-purchase agreement than in a stock redemption agreement,” says Freiburger. “Yet, 90% of the buy-sells that I review are stock redemption agreements. That’s because the advisors who recommended them didn’t think though the process.”

Perhaps. But observers point out that cross-purchase agreements involving more than 3 owners make less sense for businesses because, as the number of owners rises, so does the agreement’s complexity and cost of administration. Whereas, for example, a business involving 5 owners would require 20 life insurance policies under a cross-purchase–each partner owning a policy on the lives of other 4–a stock redemption agreement would only require 5 policies. The business itself would own a policy on each of the owners.

Assuming the business owners aren’t sure whether a cross-purchase or entity-purchase is optimal, they can also elect a combination of the 2. This hybrid agreement provides a “wait-and-see” opportunity that permits remaining owners to individually purchase the equity interest of the deceased or departing owner or shift the burden of acquisition to the company.

Or, if the owners favor a cross-purchase agreement but don’t want to buy 20 insurance policies, they can also establish a trust. As under a stock redemption agreement, a trust-owned cross-purchase agreement would only entail 5 policies, but each would be owned by the trustee.

Also to consider: whether family members are (or will be) engaged in the business. If, for example, a father plans to give control of his company to his daughter, then he needs to decide what part of her interest will be subject to a buy-sell agreement. She could receive, say, 50% of the firm within a buy-sell and 50% as part of a bequest. The father could also establish an irrevocable life insurance trust to equalize the estate for other children who will not be active in the business. Or, where a surviving spouse stands to inherit the business, a buy-sell could be used to remove the company from the estate and thereby minimize estate taxes.

If, as is most often the case, the business owners intend to fund the buy-sell agreement with a life insurance policy, then they’ll also have to weigh the merits of different insurance contracts, experts say. For those business–especially start-ups–that have limited cash resources and desire only to fulfill the terms of the buy-sell, a term insurance will often prove adequate.

But where the owners also need to accumulate a cash fund for retirement, then a permanent life insurance policy–usually, a universal life contract—becomes the vehicle of choice. Variable life policies, advisors say, tend to be risky for this aspect of business planning.

“Personally, I don’t like variable policies, but I do believe they can be intelligently applied,” says Heusinkveld. “With buy-sell agreements, it behooves us to fund them with something more solid, traditional and predictable.”

To be sure, VL and VUL policies do get used, typically where the business owners are looking for higher than average investment returns. Freiburger cites one client, a law firm comprising 5 partners who opted for a VUL-backed buy-sell agreement because of their high cash accumulation needs. A variable contract, funded to the tune of several hundred thousand dollars per year, was needed to enable 4 of the 5 partners to retire within 7 to 12 years; and to allow the 5th attorney to recruit new partners into the firm.

Potentially a more effective vehicle for the accumulation and distribution of retirement funds would be a life insurance policy placed within a business entity (such as a partnership or LLC) that is separate from the operating company. Bill Stark, an advanced marketing counsel at Securian Financial Group, St. Paul, Minn., says this structure allows partners to avoid income tax on policy gains. The independent entity also offers protection from creditors.

Potential creditor claims are, however, usually less of a concern than errors committed in the drafting of the buy-sell agreement. Among those cited by Stark: failure to coordinate the buy-sell agreement with other documents, such as shareholder agreements, power of attorney and wills; and failure to grant remaining owners first right of refusal (i.e., the opportunity to buy a shareholder’s interest before that interest is offered to others). Often, too, owners fail to incorporate installment note provisions that would allow remaining owners to buy out the interest of a departed owner in installments (as opposed to a lump sum) in cases involving an uninsurable party or where the value of the business exceeds the amount covered by life insurance.

The last frequently results when the business is undervalued because the owners used an inappropriate formula to appraise the company’s worth (e.g., book value as opposed to a typically higher fair market value).

Says Stark: “Many times, [an accurate] valuation formula totally takes the owners by surprise when you explain what their business is really worth. The valuation should always be based on a certified appraisal by a specialist.”

Rick Helbing, a chartered financial consultant and principal of Suncoast Advisory Group, Sarasota, Fla., agrees, adding that appraisals should be scheduled annually, particularly for companies that are experiencing a rapid appreciation in the value of their corporate stock.

Also frequently omitted from buy-sell agreements are provisions that provide for the buy-out of owners in the event they become disabled. Though they’re statistically more likely to suffer a disability than death during their working years, Freiburger observes that buy-sell agreements are less often funded with disability income insurance than with life insurance.

“So many times, my recommendation to the owner is, ‘If you’re not going to put disability income insurance in place, then we need to put your buy-sell agreement through a shredder,’” says Freiburger. “‘You’re better off not having a buy-sell than having one that binds you to a financial commitment you can’t meet.”‘