For business owners, retirement isn’t as simple as turning in retirement papers and walking out the door with a gold watch. For most owners, retirement is not even an event; it is rather a journey as the owner reduces and eventually discontinues involvement in the daily operation of the business.

Many owners plan to pass their business to one or more children who are ready to take over management functions and continue its successful operation. Others want to sell to remaining owners, a key employee or an outside party. In any scenario, the owner plans to use the sale proceeds to meet retirement income needs or to provide family survivor income needs in the event of a premature death.

As an advisor, your job is to help your client identify how the transition will take place, then set into motion the steps necessary to accomplish it.

From Concept To Contract

Once the transition plan is agreed on, the next step is to put the plan into writing. This is accomplished by drafting a buy-sell agreement: a legal contract that sets the terms and conditions for the sale of the business, whether at the owner’s death or during his or her lifetime.

Your client may ask, “What is so important about having a buy-sell agreement?”

When an active owner leaves the business, there may be unavoidable competing interests between family members or other owners. For example, a retiring owner may have a significant stake in the continued success of the business. Without a successor management team in place, the retiring owner may be reluctant to give up control, adding organizational stress and jeopardizing the transition. Family members of a deceased owner may also have an inflated idea of the value of the business and expect to maintain an income or be given a job.

As a planning tool, a buy-sell agreement can help ensure the orderly transfer and continuation of a business beyond the voluntary or involuntary departure of an owner. Most importantly, the terms of the sale are decided before the event takes place, when all parties have equal bargaining power and a discussion of the costs and risks of events such as death, disability or retirement can be weighed.

Buy-Sell Provisions

A buy-sell agreement typically includes provisions that:

? Create a purchase and a sell obligation to the parties named in the agreement.

? Outline triggering events that will cause a sale to take place. Common triggering events include death, disability and retirement of an owner. Other triggers may include bankruptcy, divorce or loss of professional license.

? Establish the value of the business and outline the process to value the business in the future.

? State when the sale will take place (for example, six months after the triggering event).

? Determine how payment will be made, such as a lump sum, over time or a combination of both. Often, an interest rate on the unpaid balance is included in the agreement.

Once an agreement is ready, the method of funding the buy-out should be determined, providing certainty about the source and manner of payment. Funding can be accomplished using:

Personal funds of buyers–While this method may work in some circumstances, most business owners do not have large sums of liquid assets; their money is usually reinvested back in the business or in retirement accounts.

Sinking fund in the business–As an asset of the company, a sinking fund could be tapped for other business needs. Since it is unknown when the buyout will occur, there may not be enough time to accumulate sufficient amounts.

Borrowed funds–Although a buyer may be in a favorable position to borrow funds at the time the buy-sell agreement is drafted, there is no guarantee that their financial conditions will remain the same into the future. Lenders may be reluctant to loan funds to the business at a time when the business is in transition.

Business cash flow–The seller’s estate is tied to the continued financial success of the business or of the new buyer. If installment payments are used for a sale at the owner’s death, in addition to putting a strain on the operating capital of the business, the estate may not have sufficient liquidity for estate settlement costs.

The Role Of Life Insurance

Life insurance owned by the buyer on the life of the seller is an attractive option to business owners because it avoids the question of how the buyers will pay for the deceased owner’s share in the business. The death benefit is available immediately at the death of the business owner, making it possible for surviving family members to receive the full fair-market value of the business interest.

Policies used to fund a buy-sell may be term or permanent. In situations where cost is a concern, such as in a start-up business, term may be appropriate. However, in many situations, permanent policies are preferable; if the buy-out occurs during the owner’s lifetime, the cash value of a life policy can be used to help provide part of the purchase price.

When life insurance is purchased to fund the agreement, reference to the policy or to life insurance in general should be written into the agreement. Provisions for increases in coverage in the event that the value of the business interest increases are also common. In some cases, life insurance proceeds may account only for a portion of the purchase price. In these cases of combination funding, how the excess of the purchase price over the life insurance death benefit will be paid should be stated in the agreement.

Not having a valid transition plan can create a number of uncertainties for the business owner and his or her estate. These concerns may be alleviated with a properly designed and funded buy-sell agreement.

Dorothy Vautier is an advanced sales consultant at National Life Group, Montpelier, Vt. You may e-mail her at dvautier@nationallife.com.