What is the most important question a properly structured & funded Buy-Sell Agreement answers?
If you or one of your fellow business partners were to become disabled or retired, or to pass away prematurely, who would gain control that ownership share of the business? Once that question is answered in a written Buy-Sell Agreement, the next step is provide funding so this transition can be financially completed.
There are other concerns that can be answered by a well structured Buy-Sell Agreement - assignment of day to day responsibilities, cash needs of surviving heirs, handling of different personalities - but the main question remains how to financially replace an owner if they make a planned or un-planned exit from the business.
A written but unfunded Buy-Sell agreement, while legally binding, is really nothing more than a promise that payment WILL be made, but doesn't provide the mechanism of HOW payment will be delivered. This page provides solutions and concepts to consider for funding your Buy-Sell Agreement.
The Benefits of a Funded Buy/Sell Agreement:
Buyer & Price are pre-determined.
Remaining owners are protected against unknown buyers and/or distressed sale price. Price is negotiated and set ahead of time, but should be re-visited periodically.
Cash needs are addressed.
Protect remaining owners from hardship of the loss of exiting owner's production. Help heirs replace lost income and deal with any estate taxes.
Peace of Mind.
Eliminates a lot of the uncertainty of how the business will continue after the loss of an owner. Also helps take some of the emotion out of the transition period.
The 5 ways to fund a Buy/Sell Agreement:
Life and/or Disability Income Insurance: A common method of funding buy-sell agreements is taking out an insurance policy on the present business owner or owners. This choice gives the most certainty as a funding option. Following the "triggering event" - the owner’s death or permanent disability - funds are made available to execute the buyout, which can be helpful when there is an unexpected pre-mature death of an owner. Often permanent life insurance is used, which could provide funds for a buyout after retirement. Be aware that it is advised that the insured party not have incidents of ownership over a policy on the insured person’s life so as to avoid the estate tax inclusion, under IRC 2042. Clients should always work with a legal and tax professional during this stage.
Cash: You can rely on cash on hand or stock up a cash reserve account. The issue is that many business’s capital is usually tied up in assets or inventory versus sitting in a liquid account. Using cash could put you in a position of having to sell something to fund the Buy-Sell Agreement.
Sinking Funds: A sinking fund can be a cash account as mentioned above, or some other type of investment account. In this method of funding buy-sell arrangements, business profits are held back and used to cover the cost of a buy-sell arrangement. However, if an owner dies before the sinking fund has had time to accumulate capital, business may not have enough available funds to complete the Buy-Sell Agreement.
Installment Purchase: Buy-sell arrangements can also be funded by making installment payments to the departing owner's heirs, similar to a seller financed arrangement. The heirs, or sellers of shares, would receive periodic payments versus a lump sum payment. But if a business experiences cash flow issues, the security of future payments may be lost.
Borrow Funds: A business could use a loan to fund a Buy-Sell Agreement. Issues to consider with this strategy is qualifying for the loan, particularly if the departing owner was a key contributor to the creditworthiness and/or perceived future success of the business. This strategy also impacts cash flow as well as adding interest to the buyout cost.
Types of Buy-Sell Agreements and how it works with funding provided by Life Insurance:
John Hancock is a respected vendor to independent advisors and has one of the better Buy-Sell Agreement guides you'll find. Click below to view:
John Hancock Buy-Sell Agreement Client Guide
Listen to Buy-Sell Agreements & related topics discussed on our Business Owner Strategies & Solutions (B.O.S.S) Podcast Series:
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Disclosure: A Buy-Sell Agreement is a legal document. While we do work hand in hand with a variety of attorneys at Gulf Coast Financial Advisors, by no means are we licensed legal professionals ourselves. Please consult a legal professional before assembling any significant legal document, especially one as impactful as a Buy-Sell Agreement.
Information presented on this site is for informational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any product or security. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.