Why is a buy-sell agreement necessary?
The buy-sell agreement is the document that spells out how the business will function without you. It’s a contract that enables the remaining owners, or your heir, to purchase the business interest of any co-owner who dies, becomes disabled, or retires.
Three business partners had a buy-sell agreement with a common redemption agreement – this means that if one partner die, the company would buy out the share belonging to the deceased partner. In addition, each individual partner personally owned insurance on each of the other partners.
In this case, the problem was there was nothing in place that required a surviving partner to deliver cash from the insurance proceeds to the company so that the company could complete its obligation to buy the deceased partner’s share. When a partner did end up dying, one of the remaining partners refused to give the death benefit to the person leaving the company, the estate of the deceased is short of cash, and their partner way ahead of the game.
It may take three to four years to settle this case in court. Until the case is settled, one partner is left in a good situation, and all three (including the estate) are dealing with litigation and large legal fees. This case serves as an example of how important it is to do continual reviews to prevent these sorts of issues prior to them occurring.
Different forms of buy-sell agreements:
Entity Buy-Sell Agreement:
- The business itself enters into a written agreement with the owners to purchase the interest of each individual owner. The individual owners agree to sell their respective interests to the business in the event of disability, death, divorce or departure of a co-owner. This approach may be appropriate if you’re a:
- Smaller business taxed as a partnership
- Business with multiple owners and large age differences, or different ownership percentages among their owners
- Business wishing to own and control the insurance funding.
Cross-Purchase Buy-Sell Agreement:
- The individual owners agree to purchase the interest of the other owners. Each individual is the owner and beneficiary of a life insurance policy on each of the other owners, and the policy proceeds are used to pay the purchase price. This approach may be appropriate if you’re a:
- Business with fewer partners/owners
- Business owners who are close in age
- Business with owners who are willing to personally own and pay for the insurance.
Buy-Sell Agreement Using Partnership Administration Succession Strategy (PASS):
- Under this arrangement, the individual owners form a separate partnership, and the partnership acquires life insurance policies on all the owners and administers the provisions of the buy-sell agreement. This approach can be very advantageous
Buy-Sell Agreement Funding:
- A buy-sell agreement is the foundation of a business succession plan, but you have to know where the money will come from or the plan can’t be implemented. There are only a couple of ways to fund a buy-sell agreement:
- Cash. Unfortunately, cash is not always available when you need it most and depending on your business, you may need a large amount.
- Sinking fund. With this method, you set aside funds for the eventual purchase of the business, but what if something happens before you have all the funding?
- Borrowed funds or installment note. You can always work with your bank to borrow the funds to purchase the business. However, the death, disability or retirement of a co-owner may affect your ability to obtain credit.
- Life insurance. For many business owners, insurance can be the most cost effective option. Note that the cost and availability of insurance can vary based on age, health and benefit amount, and may contain exclusions, limitations, reductions, and certain requirements.