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What Can Go Wrong Without a Buy-Sell Agreement


What Can Go Wrong Without a Buy-Sell Agreement

Family involvement in businesses is a double-edged sword. It can bring unique benefits, but it can also introduce complexities in relationships and operations. Sometimes, relatives become integral to the business; other times, they remain distant observers. Yet, nobody desires to find themselves unexpectantly partnered with the spouse or children of a co-owner. That's where strategic business continuity planning steps in.


The Role of Buy-Sell Agreements in Business Succession Planning


Buy-sell agreements are a critical part of a company’s succession plan. They provide a structured approach for determining an owner's interest value and who has the right or obligation to purchase it upon triggering events like retirement, death, disability, or departure.  This predetermined valuation can also prove beneficial for estate tax purposes when calculating a deceased owner's interest.

 

Beyond valuation, buy-sell agreements serve another key purpose: restricting ownership transfers to outsiders. This is particularly valuable for partnerships and closely held corporations, especially in professional fields like law firms and medical practices.  Many states limit ownership in these professions to licensed individuals, creating a smaller pool of potential buyers for an outgoing owner's stake.  A buy-sell agreement ensures a smooth transition and avoids complications by establishing a clear process for the remaining owners or the business itself to acquire the departing owner's interest at a pre-determined price. This safeguards the continuity of the business and prevents unwanted outsiders from coming in.

 

What Can Go Wrong


Why is it imperative to have a buy-sell agreement in place? Let's explore some scenarios where the absence of a buy sell can lead to turmoil:

 

Example 1: Disability

  • Problem: You can be tied to a partner who has become disabled and cannot bear their share of the managerial load. They need income and have a family that must be supported. The business has not planned for these contingencies and the disabled owner still owns a large percentage of the stock or is a full partner.

  • Solution: Lump-sum disability insurance, that could cover a significant percentage of this loss, is priced at astonishingly reasonable rates. Most business owners do not even know it exists.


Example 2: Departure

  • Problem: One of the owners decides he is no longer interested in working for the company and decides to sell. Without proper protocols in place, the prospect of selling to an outsider can sow discord among the remaining stakeholders.

  • Solution: A well-drafted buy/sell will include right of first refusal for the owners at a stipulated price or formula to prevent a sale to an outsider.

Example 3: Retirement

  • Problem: In a family-owned business passing on to the third generation, each family may have a different number of children. Conflicts can arise between siblings and cousins, and ownership interests may be weighted towards one family depending on how the original interests were divided.

  • Solution: Addressing this challenge requires strategic planning. By leveraging life insurance policies, the business can equalize ownership interests, fostering fairness among family members and maintaining operational stability.


Example 4: Death

  • Problem: A co-owner dies and his family inherits his interest in the business. There may be family members that have talent and interest in participating, or, there may not.

  • Solution: A buy-sell agreement paired with life insurance on each owner ensures a smooth buyout. The agreement dictates the price and buyer, and life insurance provides the essential liquidity to complete the purchase. This benefits both the deceased owner's family, who receive fair compensation, and the surviving business, which maintains control and avoids disruption.

 

In each of these situations, a well-crafted buy-sell agreement acts as a beacon, illuminating the path forward and safeguarding the interests of all involved parties.

 

Types of Buy-Sell Agreements

 

Now, let's delve into the different types of buy-sell agreements:

 

  • Cross-Purchase Agreement: Upon a Triggering Event, an owner or the estate of a deceased owner, agrees to sell their interest to the remaining owners. This type of agreement is best suited to a company with a few owners. In a cross-purchase agreement funded with insurance, each owner purchases a life insurance policy on the life of every other owner. Obviously, the more owners, the more policies must be purchased and the more complicated the plan becomes.  The benefit is the remaining owners receive a step up in basis equal to the amount of money they paid for the additional interest. In addition, depending on the state of issue, creditors of the company may not have the ability to access the cash value of the policies. The downside of a cross-purchase agreement is that each owner will have to personally pay the premiums on the policies.  This is especially problematic when there is a significant difference in the ages of the owners.

 

  • Entity-Purchase or Redemption Agreement: Upon a Triggering Event, an owner (or the estate of a deceased owner), agrees to sell their interest to the company and the company then retires the interest. This type of agreement is often the easiest to fund since the company’s assets, future cash flow or life insurance proceeds in the case of death can used for the purchase.  In addition, if it is funded with life insurance, only one policy is required on each owner and the company pays the premiums.  The negative is the remaining owners do not receive a step up in basis.  Also, the creditors of the company may make claims to the cash value in the policies.

 

  • Hybrid Agreement (often referred to as a Wait-and-See Agreement): The owners do not decide on whether it will be an entity-purchase or cross-purchase until there is a Triggering Event, allowing for more flexibility in the structure of the buyout. This type of agreement gives the company the first option to purchase the owner’s interest.  If the company does not exercise its option, the remaining owners will have an option to purchase the departing or deceased owner’s interest. If the remaining owners do not exercise their option, generally the company will be required to purchase the interest.

 

Funding Buy-Sell Agreements

 

To be successful, a buy-sell agreement should be funded to ensure a successful transfer of ownership. The company or remaining owners must pay the withdrawing owner or heirs of a deceased owner. The funding can be accomplished in several ways:

 

  • Life and / or disability insurance (including lump-sum disability coverage)

  • Installment note

  • Cash

  • Selling assets

  • Borrowing

  • A combination of any of the above

 

The funding method will depend on various factors, such as business structure, cash flow, nature of the Triggering Event, ownership percentages, tax considerations and the ages of the owners.

 

Funding a Buy-Sell Agreement with Life Insurance

 

While funding with term insurance may be less expensive in the early years, it only provides funding in the event of death and not a lifetime buyout. Furthermore, at the end of the term, the cost of a new policy may be prohibitive. Cash value life insurance is a popular method to fund the buyout because it will provide cash to buy out a deceased owner’s interest and can act as a tax-deferred sinking fund to buy out a retiring or departing owner. In addition, buying the interest in the company with life insurance proceeds does not put a financial strain on the company and ensures the seller’s family does not have to rely on the future success of the company for installment payments over a specified term.

 

In the ever-shifting landscape of business ownership, a well-crafted buy-sell agreement offers continuity, stability, and harmony within the enterprise. By embracing foresight, strategic planning, and financial tools such as life insurance, businesses can navigate the complexities of ownership transfer with confidence and resilience. To learn more about implementing effective buy-sell agreements, contact NFP today for expert guidance and tailored solutions.

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