A buy-sell agreement is a legally binding contract often used by business owners to govern the sale and transfer of ownership interests in a company. These agreements are crucial for maintaining stability and continuity within a business, particularly in the event of triggering events, such as death of an owner.
When a business has multiple owners, a buy-sell agreement outlines the terms and conditions under which an owner’s interest can be sold or transferred. In the case of an owner’s death, the agreement can provide a structured process for the deceased owner’s estate to sell their stake in the company to the surviving owners or the business itself. Life insurance plays a vital role in facilitating this process.
To address the death triggering event, business owners often purchase life insurance policies on each owner’s lives. In the event of an owner’s death, the life insurance proceeds are used to fund the buyout of the deceased owner’s interest. This arrangement ensures that the surviving owners have the financial means to buy the deceased owner’s share at a predetermined price, preventing the need for liquidating the business or bringing in unwanted outside investors.
Life insurance policies can be structured in various ways to align with the buy-sell agreement’s terms and the business’s specific needs. Common options include cross-purchase agreements, where each owner holds a policy on the lives of all other owners, and entity-purchase agreements, where the business itself owns the policies.
Buy-sell agreements are essential legal documents for businesses with multiple owners, as they establish a clear framework for addressing triggering events like death. Life insurance is a key financial tool used to fund the buyout of a deceased owner’s interest, ensuring a smooth transition of ownership and business continuity.
Benefits of a Buy-Sell Agreement
- Create Liquidity: Upon a business owner’s disability, retirement, or death, his or her family continues to need cash to pay ordinary living expenses as well as any potential estate tax liability. Estate taxes are usually due nine month after date of death. Selling a business under these circumstances can result in the family receiving less than fair market value.
- Set a Fair Selling Price: A business valuation strategy, while all owners are active, remains subject to arm’s length negotiations. Once a business owner has left the business, negotiating a fair sales price becomes more difficult for the owner (or the owner’s estate) because the remaining owners hold most of the cards.
- Fix Value: A buy-sell agreement ordinarily sets the valuation for estate tax purposes. This allows the owners to plan their estates and reduce the risk of costly valuation disputes among business owners or upon estate tax audit.
- Maintain Harmony: Because of the pressures of business ownership and everyday life, it is often difficult for owners of a closely held business to maintain friendships and camaraderie. Maintaining harmony becomes more difficult after the family of a deceased owner enters the business. A buy-sell agreement can protect the remaining owners from problems arising when a deceased owner’s family joins the business.
Risks of Unfunded or Underfunded Buy-Sell Agreements
- Interest Rate Risk: The interest rate, specified in the agreement, to be used for installment payments is usually pegged to something that can change (e.g., the prime rate).
- Cash Flow Risk: If cash flow will be used to fund an obligated purchase, the buyer might not have the cash. If the cash is coming from the business, the viability of the business as an ongoing concern can be compromised.
- Illiquidity Risk: The owner’s net worth is overly concentrated in the business. Upon the death of the owner, the surviving family members may have relatively little liquidity on hand to meet its needs.
- Credit Risk: The surviving family members who are accepting installment payments, become creditors of the business or the buyers. There could be an actual default on the payments thus causing the family to receive little or nothing of the remaining installments.
Four Ways to Fund a Buy-Sell Agreement at an Owner’s Death
- Cash Method: The purchaser(s) could accumulate sufficient cash to buy the business interest at the owner’s death. Unfortunately, it could take many years to save the necessary funds, while the full amount may be needed in just a few months or years.
- Installment Method: The purchase price could be paid in installments after the owner’s death. For the purchaser(s), this could mean a drain on business income for years. In addition, payments to the surviving family would be dependent on future business performance after the owner’s death.
- Loan Method: If the new owner(s) could obtain a business loan, borrowing the purchase price requires that future business income be used to repay the loan PLUS interest.
- Insured Method: Only life insurance can guarantee that the cash needed to complete the sale will be available exactly when needed at the owner’s death, assuming that the business has been accurately valued.
Triggering Events to Consider in Addition to Death
- Involuntary transfer due to bankruptcy or divorce
- Business disputes
- Termination of employment