Starting a business is an invigorating process. All founder energy is focused on the success of the new enterprise.
For that reason, the founders often overlook an essential element of business planning: designing the exit strategy.
Creating a formal buy-sell agreement from the start will mitigate risks that could hinder, or even destroy, your client’s business down the road.
Simply stated, buy-sell agreements are the blueprints that guide any eventual buyout, sale, divorce or death of an owner. Most commonly, buy-sell agreements are put in place to protect the family of an owner if a partner dies, is debilitated or decides to exit or retire, while allowing the remaining owners to move the business forward.
(Related: 4 Key Buy-Sell Agreement Basics)
Another common occurrence is the passing of the baton, or transition of the business ownership to a current employee or outside individual. The buy-sell agreement can include a provision to pay the taxes on the transfer of ownership to the new owner, while protecting the company’s cash flow to keep business operations running smoothly.
An insured buy-out agreement uses life insurance to ensure that funds will be available to pay for the execution of the agreement. Many buy-sell agreements also incorporate disability insurance.
With any business agreement, having a cadre of advisors is critical, and for this particular agreement, having a legal team and a business advisor at the table, as well as a life insurance advisor, can prove invaluable.
Below are the three most relevant buy-sell agreements when it’s time for an owner to give up his or her stake in a company.
- Cross Purchase Agreement: This structure is for two or more parties and is utilized during ownership changes when shares are crossed over to other owners.
- Stock Redemption Agreement: In this structure, the entity, or the business, is the focal point and if shares are exchanged, the entity will repurchase them. This structure gives owner(s) peace of mind that they can sell shares back to the entity, if needed.
- Combination Agreement: This structure gives owners the option to do either of the above, meaning they can sell their stake to either the entity or to other owner(s). The structure of the combination agreement will determine the right of first refusal between owner and equity. This strategy provides tremendous flexibility to both sell and purchase additional shares, and is commonly used to ensure shares remain with the original owners.
A buy-sell agreement could involve a family patriarch with several adult children who love each other, and the business — and spouses or grandchildren who see everything differently.
When that kind of owner lacks a well-designed, well-funded buy-sell agreement, the result could be a failure to treat family members in similar situations in a similar way, emotion-driven decisions about the business, and permanent family rifts.
The most common mistake in developing a buy-sell agreement is owners not properly answering, ‘how much do we need to fund the agreement?’ Using a business advisor to quarterback this process is highly recommended, as too often owners take shortcuts during the process and valuation details are overlooked, resulting in poorly funded buy-sell agreements.
It’s essential to conduct not only an early valuation of the business, but to continuously review the valuation over time to ensure the agreement is properly funded based on tax changes, business growth and savings through structure.
After a business is properly valued, then the question of ‘how to fund’ can be answered. The most efficient and effective way to fund buy-sell agreements is through life insurance. In the event of a partner’s death, using life insurance to fund buy-sell agreements prevents family members from inheriting a stake in the company, allows quick access to liquid assets, and through the death benefit, supports the partner’s family, income tax-free.
Choosing a term life insurance policy provides owners flexibility to change over time, and the cost is one many owners want to contain.
If a business continues to grow, building sufficient capital, its equity value can eventually “self-insure” the buy-sell agreement. Once the agreement is self-insured, the life insurance expense can cease, or be dialed down to a nominal policy cost.
Alternately, funding a cash-value life insurance policy offers owners protection, cash growth and death benefits, providing flexibility in the face of business and personal challenges. For example, a cash value policy could be used to buy out a partner and fund a down payment, while pairing with a payment schedule to fund a replacement partner over time.
This strategy can also provide supplemental, tax-free income for the owners and their families. Life insurance agents like you are critical in determining the proper structure, to ensure cash value policies provide owners with the funding for any curve balls life might throw their way.
While it can be a difficult conversation to have, a buy-sell agreement is a fundamental element of the business planning process. Advisors should remind business partners that having a plan in place, and updating it regularly, will ensure a prosperous future for themselves and their families.
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