Have you taken the steps to ensure that your business will continue to run smoothly if you were to lose a business partner? Have you considered what will happen in the event of divorce, disability or even worse, death?
A buy-sell agreement can establish the value of the business, assure that there is a buyer for the business and improve creditworthiness of the business. Think of a buy-sell agreement as a formal exit strategy that ensures everyone is treated fairly, the business is in a position to continue and the family is well cared for.
With a buy sell agreement, the business owners enter into the agreement today that sets out the terms and conditions of the sale of their business interest at some point in the future.
These terms and conditions may include (but are not limited to) who will purchase the interest, what triggers the buyout, when the sale will take place, the value of the interest, how the purchase price will be paid and more.
- Entity Purchase Agreement (Sometimes called a Stock Redemption Agreement): Under this agreement, the buyer is the business. The business owners agree to sell their ownership interest back to the business if they become disabled or wish to retire. If there is a death of an owner, the owner’s estate is required to sell the deceased owner’s interest back to the business.
- Cross Purchase Agreement: The co-owners will purchase the selling owner’s business interest. The business itself will not be involved in the purchase.
- Wait-and-See Buy-Sell Agreement: This agreement allows the business owners to delay the selection of an entity purchase or a cross-purchase buy-sell agreement until an actual death, disability, retirement or sale of a business interest. The agreement establishes a series of options usually starting with an option for the business to purchase the interest. If the business doesn’t make the purchase then the cross-purchase option is triggered. Many agreements have additional options triggered if the cross- purchase option is not exercised.
Once you determine which agreement is best for your business, your attorney will draft the agreement. The agreement will spell out all of the details with some of the key areas being:
- The trigger events (death, disability, retirement, termination, divorce, bankruptcy)
- Who will purchase the interest (the business, co-owners, key people, third parties)
- The value of the business (set price, formula)
- How the price will be paid
Having a formal buy-sell is important, but just as important is making sure the money is there to complete the buy-sell.
There are a number of ways to fund a buy-sell agreement:
Cash on Hand
Unfortunately, cash (surplus cash!) is not always available when it’s needed most and depending on your business, the amount may be substantial.
Think of this as a savings account. With this method, money is set aside for the eventual purchase of the business. It’s a little more certain than hoping to have cash on hand, but what if something happens before the money you need for the buyout has accumulated?
Borrowed Funds or Installment Note
Another option is to borrow funds from a bank or from the selling owner to purchase the business. However, the death, disability or retirement of a co-owner may affect the ability to obtain credit from a third party. Borrowing the money from the seller through an installment note is often used as a back-up plan, when used as a primary method of funding a buyout it raises many concerns. Can the family afford to receive the buyout funds over the installment period? What happens if the business cannot sustain itself with this new debt? Will the family receive the whole buyout price?
For many business owners, insurance can be the most cost effective option. The life insurance death benefit can provide the needed cash to complete a purchase at death and the cost to purchase the insurance may only be pennies on a dollar. For lifetime buyouts in the event of divorce, disability or retirement, the policy cash value can be accessed through loans and withdrawals to supplement funds needed to complete the purchase. Note that the cost and availability of insurance can vary based on age, health and benefit amount. Policy loans and withdrawals reduce the policy’s cash value and death benefit and may result in a taxable event.