As a business owner it can be both exhilarating and frustrating when navigating your business ship. Oftentimes business owners will partner with other people either from the onset or as the business grows and complexities arise. It can be easier to share responsibilities and have complementary skill sets to one another. Two heads are usually better than one – assuming they like each other and can get along most of the time.
Working with people can be difficult but if you have a good partnership beautiful things can happen. Regardless, you want to be sure to have your affairs in order should something happen to your business partner. You may need to buy them out and potentially find a new partner. This is where a buy-sell agreement comes into play.
What is a Buy-Sell Agreement?
A buy-sell agreement is a contract between business owners to buy the other person out in the case that something happens to one of them. For example, this can be incapacitation or death.
Before getting started, always consult a business attorney when constructing a buy-sell agreement. They will help you think through pitfalls to ensure everything is set up on the front-end to avoid costly mistakes or issues before it’s too late.
These agreements can be very important for small businesses with multiple owners. A common way to structure one is to value each owner’s share of the business. Language is put into the agreement that will define the conditions that prompt a buy-out. Death is a common one. If one owner passes away then their share of the business will be bought out by the other owner or owners.
Typically, there is a mechanism to fund the buy-out in the contract. Funding can be established and budgeted for when the agreement is set up.
A common example is life insurance. A policy will be taken out for each owner and the other owner(s) will be the beneficiaries. Each person’s interest is usually valued on the front end.
You would obtain enough life insurance coverage to buy the other owner(s) out. The policies are usually paid for by the business entity or owners. If they were to pass the policy would payout and then the other owner(s) would use the proceeds to purchase the deceased owner’s interest either from their estate or spouse as an example.
There are more technical terms when referencing buy-sell agreements. These are cross-purchase agreements and entity or stock redemption purchase agreements. Each of these has their own attributes and functions.
Types of Buy-Sell Agreements
A cross-purchase agreement is where the other business owners will buy out the individual’s interest in the business. The life insurance proceeds are payable to the other partner and the proceeds are used to buy their interest.
Entity Purchase Agreement
An entity purchase agreement is where the actual business entity buys back the owner’s interest. It is also referred to as a stock redemption agreement.
In this case, the owner of the life insurance policy would be the business, such as “ABC Corporation” owning the policy, making payments, and then using the life insurance proceeds to buy the shares of the deceased owner.
Funding Options for a Buy-Sell Agreement
The funding options for a buy-sell agreement are:
- Life insurance
- Sinking fund or trust
- Installment plans
Succession planning for your business is very important. Business owners may want to consider getting a buy-sell agreement in place to avoid disruptions in these scenarios. This can help value the business on the front-end and create a market by having a buyer ready for your shares.
There is not a cash or liquidity issue when trying to sell the business either. Liquidity can be problematic if one is forced to sell during an emotional time such as death and there is no buyer in place. In this event, you could be forced to sell at a major discount.
Not having a buy-sell agreement in place could leave an executor or trustee who is not prepared to handle the business or has the expertise to sell the business. It could create a lot of undue stress and financial worry.
Do yourself, and your loved ones, a favor and plan accordingly for your business. A buy-sell agreement isn’t always necessary but it is a useful tool when needed. Plan ahead and think through the likely and unlikely scenarios for your business and how to transfer ownership when it comes time to do so. This can save money, time, and stress.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ at Applied Capital. Email him at [email protected] or fill out a contact form.
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