Now is a tremendous time to call on your small business owner clients or prospective clients to talk about buy-sell agreements–to review the one they have or to create the one they should have.
It is not lost on small business owners that the value they receive for their business in the event of death, disability, retirement, or sale is as important as ever. But that doesn’t mean they are doing anything about it. That’s where you as an advisor come in.
You might wonder if asking clients to review their “succession plan” would be better, as it might address more global issues. Although these terms can, in some cases, mean the same thing, the term “succession” can often carry with it more baggage than a small business owner may want. Furthermore, there is plenty of room to go global in the buy-sell agreement discussion, so be specific to ask about reviewing the “buy-sell agreement.”
Cornerstone of the plan
The buy-sell agreement is often the cornerstone of a succession plan; it is a key piece of the bigger puzzle, and if clients don’t have one, there is no way to hide it. If you ask when the last time it was reviewed, and they have to think about it, you can help them. If someone can honestly tell you he or she has reviewed the agreement within the last year and that it is up to date and funded, simply congratulate the individual and call on the next person on your list.
What this planning attempts to accomplish is to avoid surprises or conflicts for business owners and their families. A buy-sell that everyone agrees to and reviews regularly should eliminate the surprises, such as: no funding, dispute as to the sale price, a missed contingency or a sale offer that is less than a desired value. All of these surprises, and others, lead to headaches, fighting and un-productivity.
Your most important job is keeping your client focused on the big picture goal as the details are reviewed and debated. This is easier said than done, but shepherding these discussions while things can be thought through without pressure or dispute is meaningful and important work.
You don’t have to know all the legal aspects of buy-sell planning, but you do need to know the basics and the key questions that must be both asked and answered.
A buy-sell agreement is like a pre-nuptial agreement for business owner shareholders or partners. It is also sometimes referred to as a “business will.” The agreement is a legally binding contract (either separate from or a part of the partnership or business operating agreement) that controls future ownership of the business. It covers the potential “what-ifs” that could occur.
Those what-ifs include death, disability, retirement, the sale to a third party, bankruptcy and divorce of an owner. The idea is to preserve the continuity of the ownership of the business and to ensure that both the buyers and sellers feel the deal was fair. Along with the events that trigger a buy-out of an owner, a good buy-sell agreement will also detail who can buy shares of the business and at what price.
There are 4 primary forms of buy-sell agreements: (1) an entity (also called repurchase or entity redemption) agreement; (2); a cross-purchase agreement; (3) a wait-and-see (or mixed agreement); and (4) the no-sell buy-sell agreement.
In an entity arrangement, the business entity itself (corporation, LLC, partnership, etc.) is obligated to purchase the owner’s interest in the business if one of the named triggering events occurs. In a cross-purchase arrangement, the surviving owners are responsible for acquiring the interest of a fellow owner who has died, retired, or become disabled.
The wait-and-see approach allows for flexibility in that the surviving owners can delay the selection of an entity or cross-purchase buy-sell plan until one of the triggering events occurs. The no-sell buy-sell is for owners who want the future appreciation of their stock to go to heirs, but not the outright ownership. Therefore, the agreement passes control of the business to surviving owners, but non-voting interest stays with an heir or heirs.
Some plan must be in place to pay for the obligations created under the agreement. Typically, insurance is used to create cash at the time of death or disability. In an entity agreement, the insurance is owned by the business entity and it is the beneficiary. The face amount (death benefit) of the policy equals the purchase price stipulated in the legal agreement. In a cross-purchase agreement, the individual owners own policies on one another and use the policy proceeds to purchase the deceased owner’s interest in the business.
Disability income products exist for funding the buyout of an owner who becomes disabled. One must be familiar with how these function and how they are priced. DI is as important as life insurance.
Life insurance is crucial too, and if permanent life insurance is used, the cash can provide dollars in the event of retirement or departure via bankruptcy or divorce. Of course, other investments or cash can be used, but cash-value insurance makes tremendous economic sense.
As a financial professional, you are counted on to explain the ways in which the insurance should be owned, how to designate the beneficiary, the pros and cons of the insurance to be used and which products and carriers make sense. For example, you need to understand that a corporate trustee may be suitable, especially when a cross-purchase agreement is desired, but too many policies would be required. It can get complicated, but work hard to keep it simple. Again, keep yourself and your client focused on the big picture.
Attaching a value
Valuation of the business is also a key component of buy-sell planning. The objective is to get as close as possible to the fair market value for the business. This is often easier said than done, as each business owner may have his or her own belief in the value of the company. Although the details of each are beyond the scope of this article, understand the basics of these valuation methods: book value, discounted cash flow, capitalization of earnings, and sales multiple valuations.
Don’t let your client over-think the valuation. And be sure to keep this part of the process moving; far too many agreements don’t get done because of disagreements as to valuation. Sometimes the owners can simply agree to a number and fund the insurance to that level.
Helping small businesses review their buy-sell agreements and succession plans is a great thing to do today. You’ll be doing right by your clients and doing well for yourself.
Vernon W. Holleman, III, is president of The Holleman Companies, an insurance advisory firm Chevy Chase, Md. He can be reached at [email protected].