Buy-Sell Considerations For Business Owners
In order to really understand the buy-sell discussion, ask yourself the following questions.
- What would you do if you lost a key partner?
- Do you want to go into business with your partner’s spouse or family?
- Do you have sufficient cash reserves to buy out the deceased owner’s share?
- How would it feel to use revenue to buyout a deceased owner’s family?
- Does your retirement plan reflect the sale of your business?
- If you died today, what would the consequences be to your business, business partners, subsidiaries, employees, customers, debtors, creditors?
- If you were to unexpectedly pass away, would your family understand the transition of your business, and they were treated fairly?
These concerns can be solved by using life insurance to fund your buy-sell agreement.
Without a business continuation strategy in place, survivors, including family members, remaining owners, and employees, may be left with many issues and problems to deal with after the business owner’s death. Some of these issues include the following:
- Surviving business owners may want to reinvest profits while the deceased owner’s estate wants annuity payments.
- Stock-redemption needs to be clearly laid out.
- Creditors may question the company’s business interest and ability to maintain the level of profitability necessary to service loan obligations.
- There may be no established market for the business and the estate may not be able to secure a fair market price for the business.
- The surviving family is losing income.
- Owners are forced to finance the buyout over a term of years with after-tax dollars during a time in which the company has experienced a substantial financial loss of a key person.
- Obtaining a loan after the death of a key partner may be difficult until the business has proven its ability to sustain and grow.
Two Common Ways to Structure Buy-Sell Agreements
There are many ways to structure buy-sell agreements, here are two of the most common ways these agreements are structured:
Cross-Purchase Agreement (Personally Owned)
Cross-purchase agreements are agreements between each business owner and address each owner’s interest in the business. For example, if you are working with three business owners with equal ownership, each business owner would own life insurance policies on the other two partners. Then they would name those partners’ families as beneficiaries on the respective policies. If a triggering event occurs this would provide immediate funds to buyout the ownership interest of the deceased partner. Each Owner/Partner would need to Own and pay for the policies they buy on their respective partners.
Below is an easy way to figure out how many life insurance policies you need to write in order to fund a cross-purchase agreement. As you can see from the example above, there are six life insurance policies needed for this cross-purchase plan scenario.
N (Number of Partners) x (N-1)
3 * (3-1) = 6
Cross-purchase agreements can provide some benefit in the planning process but are often not implemented because of the number of life insurance applications needed per each owner and the maintenance of these policies once they are in place. This type of planning can also be challenging where there is a big age difference among owners.
Entity Purchase Buy-Sell (Business Owned)
Entity purchase is the most common and cost-effective way business owners fund buy-sell agreements. This is because it is simple and easy to understand, and less maintenance for each individual owner. This type of agreement also removes the difficulty of explaining the price differences due to the age or health of each partner since the business will pay for all policies (vs. each owner paying as stated in the Cross-purchase agreement).
In an entity purchase agreement, the business is the owner and beneficiary of the life insurance policy in order to buy out ownership from the deceased owner’s estate. This makes it possible to have only 1 life insurance policy for each owner.
What to Know before completing our Buy-Sell Process
We have made a simple, easy-to-use process to help you in establishing an Entity Purchase buy-sell agreement. In our process, we will provide you with a business valuation (or you can use a professional valuation that has been provided to you), a clear structure of death benefit for eash owners’ percentage of ownership, and a PDF summary for you to share with your partners and keep on file. Below are some key pieces of information you should have prepared and you can get through our process in only a couple of minutes!
- Type of Business: What type of business entity? Sole proprietor, LLC, Partnership, S corporation, C Corporation, etc.
- Ownership interest: Who owns the business? How many owners and what are their respecting ownership interests?
- EBIDTA: Earnings refer to earnings before interest, tax, depreciation, and amortization (aka EBITDA). EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
- Long-term Growth Rate: This rate is the growth rate for the business, expressed as a percentage, used to project growth on a long-term horizon. This rate should be more conservative than the projected growth of the earnings rate used.
- Assets: Business assets are adjusted to reflect fair market value, or the liquidation value of the business, as opposed to the depreciated value for income purposes.
- Liabilities: Liabilities of the business, typically debt or other debt instruments.
With this information, we can help you structure the funding plan for your buy-sell agreement as well as have each owner apply for life insurance in minutes! No need to schedule a call to talk with an agent, we will walk you through the entire process.
Buy sell agreement is a critical element of a business succession plan and it’s most commonly funded using a life insurance policy.
Business owners use life insurance for various strategies in their business such as buy sell and key-person funding, attraction & retention programs, and more.
There are key pieces of information needed to get a buy-sell agreement funded and with a little upfront planning, the process can go very smoothly.