What are Buy-Sell Agreements
A buy-sell agreement is a contract that prescribes how a business will pass after the death, disability or voluntary termination of one of the owners. It is a controlling device in facilitating business succession. Its fundamental purpose is to set up the way in which one owner can be bought out by the other owners at the time of their death; other life events are also important considerations. A buy-sell agreement can offer the comfort of a pre-established plan and the added benefit of establishing a funding source to pay in part or in full the buyout price. A purchase of the business interest at the value set forth in a buy-sell agreement is typically funded with a life insurance policy, the benefit of which is payable to the deceased owner’s family in an amount set forth in the buy-sell agreement. In addition, a buy-sell agreement can be funded by disability income insurance, providing funds to cover the purchase price under the buy-sell agreement in the event of a disability , or disability insurance may provide funds to allow a surviving owner to continue to operate the business while waiting for the disability of another owner to end or until he is able to buy out the disabled owner upon the disability’s end. A variety of plans are available for business owners, such as cross-purchase plans, corporate entity redemptions, entity trusts and hybrid plans. The method selected will depend upon the ownership structure and individual circumstances of the owners. One plan is for co-owners to covenant to purchase (or to cause their entity to purchase) the portion of a business owned by any owner who dies, becomes disabled or voluntarily separates from the business. The purchase price may be set at a fixed amount prior to any triggering event, or it may be determined at the time of a triggering event based on an agreed-upon formula or valuation procedure.
How Do Buy-Sell Agreements Function with Life Insurance
Business life insurance is commonly used in a buy-sell agreement to insure the value of a partnership or corporation going forward. When one partner dies, it’s likely that their share will go to their spouse or family. However, they are unlikely to be experienced in the workings of the business. The buy-sell agreement will provide for the insurance death benefit to be paid to the remaining partners or members of the business so the deceased partner’s share can be purchased and transferred to the spouse’s name.
The agreement is usually in the form of an agreement between each partner and the company or between all of the partners. Commonly, the insurance policy will have the company, or the other partners listed as the beneficiary. The purchase price will be agreed upon between all partners and will set the purchase amounts. If there is a substantial growth in the company, this will have to be reviewed and revised.
One of the most popular methods is a cross purchase plan. A cross purchase plan works like the agreement above but the remaining partners purchase the deceased partner’s share and purchases and owns the life insurance. This avoids increased insurance premiums that may be required under the plan above as the business grows or has a substantial increase in value. The death benefit will be paid to the remaining partners (now owners) and tax liability will be avoided.
Various Types of Buy-Sell Agreements
There are two primary types of buy-sell agreements: cross-purchase agreements and entity-purchase agreements.
Cross-Purchase Agreements
A cross-purchase agreement is a buy-sell agreement in which an owner of a business sells his ownership interest to the remaining owners of the business. Each remaining owner is typically required to buy a proportionate share of the ownership interest of the departing owner. This kind of agreement is appropriate only when there are two or more owners of a business.
Under this agreement, each owner obtains a life insurance policy on the life of the other owners. In the event of the death of an owner, the policy can be used to purchase the deceased owner’s interest in the business from his or her estate. The estate receives the cash proceeds of the policy, and the business owners receive a business interest which likely is worth much more than the amount being paid to the estate under the purchase agreement.
In the event of the total and permanent disability of any owner of the business, an owner may be required to purchase the disabled owner’s interest. If that is the case, the owner may be required to buy the disabled owner’s interest even though the disabled owner is no longer able to work in the business. The insurance policy provides the required cash proceeds to complete the disabled owner’s financing.
The agreement can be structured to allow the disabled owner to continue to receive some compensation for his or her hard work up to the time of her permanent disability. Thus, the disabled owner may continue to receive wages or a management fee after the business is required to purchase his or her portion of the business interest.
Entity-Purchase Agreements
An entity-purchase agreement is a buy-sell agreement in which the business entity itself agrees to buy the business owner’s interest in the business. This agreement can apply to a corporation, a limited liability company, and a partnership. Some businesses operate under a partnership agreement which requires the business itself to buy the owner’s interest in the business. Other such agreements require the owners of the business to buy the business interest of a deceased owner for the business itself.
This agreement is typically more complex than a cross-purchase agreement, because the business terms must be compatible with the rules governing the formation and operation of the business organization.
Advantages Of Buy-Sell Agreements
A properly structured buy-sell agreement has many benefits for your business. Continuing from my last blog post, here are some of the benefits:
- Business Continuity. If a partner dies, has a disability, loses his or her license, or becomes a felon, the buy-sell agreement provides for the orderly transition of ownership among the remaining owners, so the business can continue without undue disruption.
- Financial Security. The value of a business interest is usually unknown until the event that triggers the buyout. A properly structured buy-sell agreement sets the sale price for; (i) any buyout caused by death, disability, disqualification, divorce, or bankruptcy of an owner; and (ii) a voluntary buyout at any time. Employees, customers, and vendors will look to the business for stability in times of change. Do not allow uncertainty about the value of the business interest to negatively impact the company and its stakeholders.
- Flexibility. The buy-sell agreement defines the trigger events, the purchase price, the purchase obligation of the buyer and seller, the installment sale terms between the parties (if applicable), and the interest rate to be earned by the "seller" for the deferred installment purchase price. It provides a roadmap to follow for the sale of the business interest. Depending upon the flexibility of the agreement, it may enable the partners to transfer their ownership in order to close upon a sale of the business interest to a third party who might want to keep the existing owners in working roles (if they are healthy enough).
- Non-Medical Agreement. Often, business owners do not want a buy-sell agreement that is funded with life insurance policies. They do not want to have to undergo medical exams, blood tests, HIV tests, etc. to get the life insurance policy in place. If the buy-sell agreement allows for a cash buyout instead of life insurance funding, those tests may not be necessary.
- Discretion. Often, business owners are concerned about being forced into a buyout, whether because of a reduction in equity ownership or some other reason. A properly drafted buy-sell agreement enables a partner to have a "nuclear option" if he or she wants to leave the business at a defined future date.
- Taxation. A buy-sell agreement can also be structured to minimize the tax implications of a sale of the ownership interests of the business entity.
- Attractiveness to a Lender. Lenders like the idea of a buy-sell agreement, because it provides the bank with certainty as to the ownership of the business entity. In this regard, however, it is important to put the entire deal on the table with respect to the lender. If the business entity has a debt need, the lender should be aware of all of the amounts being utilized for startup costs, working capital, asset purchases, purchases of investments, distributions to partners, etc. All of these amounts are considered as requiring the use of cash and they are competing against the needs of the bank. If the lender inquires about retirement plans, which in recent history many have, the fact that the buy-sell agreement has a retirement feature should be disclosed.
Issues to Consider in the Drafting of Buy-Sell Agreements
The drafting of a buy-sell agreement for use with life insurance typically involves a number of important considerations, including the selection of a valuation method, the determination of triggering events and the drafting of various legal provisions. The most common options for determining business value are the following: To the extent possible, buy-sell agreements should include clear definitions of all relevant terms and express conditions precedent to enforceability. There are always some conditions that must be fulfilled prior to closing. These can include proof that ownership interests are properly conveyed by the deceased or disabled owner , that the proceeds of the life insurance coverage are used to purchase the ownership interest and that the buyer receives notice from the seller if the rights under the buy-sell agreement are assigned to a third party purchaser or charitable organization. Many buy-sell agreements expressly prohibit such assignment. Additional considerations may include appraisal, arbitration procedures, payment obligations, notice requirements and governing law.
Common Issues and Their Resolutions
Open and honest communication is critical for a successful buy-sell agreement and there are common challenges that can come into play. While they can be difficult to discuss, facing these proactive hurdles head on can help you avoid headaches later on.
Challenge: Inconsistencies in the business value.
Solution: Schedule periodic valuations of your business and incorporate these into your buy-sell agreement. Similarly, as the effective date for your buy-sell agreement approaches, you should do an informal check on the current value of your business relative to the value set forth in the buy-sell agreement. Things can change and you don’t want to be caught in a situation where the buy-sell agreement is out of sync with the current reality.
Challenge: When can you substitute a party into the agreement?
Solution: Typically, a party’s interest in the business is automatically lost upon his or her death or incapacity. Substitution via gift or sale is typically either required to be approved by all parties involved, or is optional, at the discretion of the other parties. Review your buy-sell agreement carefully to understand the rules for substitution and, if necessary, incorporate your own rules for substitution into the buy-sell agreement.
Examples and Case Studies to Illustrate
Buy-sell agreements have been utilized successfully for decades in businesses all across our nation. The following is a few examples of buy-sell agreements that have proved to be beneficial in the past.
Example One:
The Smith Family Foundry Company has been owned and operated by the Smith family since it was created more than 75 years ago by Grandfather Smith. The foundry makes custom metal castings and provides coatings to customers in over 25 states. It was evident to the Smiths that their business had a lot of value and would probably be sought after by a number of suppliers and local businesses in the area. The Smiths have accumulated significant wealth through their successful business venture, but they want to provide for their other children not involved in the company. Grandfather Smith’s son, Frank, is president. Frank’s sons, Brian and Will, are both officers and will likely take over the business when Frank retires in a few years. While employed in the family business, the Smiths had just one life insurance policy on Frank, and it was to pay a business debt. To finance the buy-sell agreement at this point, the Smiths thought it would be acceptable to simply use a self-funded program where the company would gradually buy out Frank’s ownership interest. Little did they know what would occur when tragedy actually struck!
Example Two:
Frank Smith purchased a life insurance policy on his business partner, who wanted to name a cousin as his beneficiary and not his wife. Frank insisted that the death benefit be payable to the company since "we are already paying the premiums—why not make the death benefit payable to the company at his death so we can use it to keep the company going?" Frank used the company funds to pay the premiums from time to time, but he never got around to formally amending the policy’s beneficiary designation. A few years later, the wife of Frank’s business partner killed him and then took her own life—both just after their annual Christmas party. Since there was no beneficiary named on the policy, the proceeds went to the ex-spouse of Frank’s business partner. Frank could not believe it! The company ended up going bankrupt.
Example Three:
Brian and Will Smith were now in charge of the family business. Frank had a small life insurance policy on each of their lives after he learned of the need to fund a buy-sell agreement at his death. Brian and Will were able to continue making payments to purchase the business, but only after a bank insisted on a $2 million loan to buy out their father’s one-third share. Since neither Will nor Brian had the finances to repay the loan, they had to sell the company to the bank for less than what the company could have been worth if the buy-sell agreement had been properly funded.
Summary
In conclusion, the buy-sell agreement is an essential component in the realm of life insurance that organizations must take into consideration. These policies not only help to solidify the future of a company , but they also serve a critical purpose in ensuring that every person involved with the business has some form of financial continuity as well. It is highly recommended for any organization to discuss this topic at length with both a legal and financial professional to determine if a buy-sell agreement is right for their case.