Undoubtedly, the most valuable employees of any business are its owners. They are the foundation of the business. They are the organizers and operators and have taken on a financial risk above and beyond every other employee. Their expertise and experience are irreplaceable, with a value far beyond the amount of stock they own.
If one owner dies, a share of the ownership can pass to their heirs in a partnership. Heirs and family members may have no interest in assuming an ownership role. They would prefer, instead, a buy-out.
On the other hand, as wills are probated and heirs engage in disputes over the operation or liquidation of the company’s shares, things can get messy. Even if there is a buy-sell agreement in effect, the amount of cash going to the heirs or from the partner’s coffers can have a negative effect on the company’s valuation.
That is unless the agreement is a funded buy-sell through insurance.
Definition of a Buy-Sell Agreement
A buy-sell agreement is a legal contract between joint owners of a business or professional practice. It could be part of a shareholder, operating, partnership, or another type of agreement, and its purpose is to:
- Prevent the ownership of the company from passing to unwanted third parties or prevent a takeover by restricting the transferability of shares
- Ease the sale of shares in the business and provide purchase access to desirable buyers
- Provide a source of funds to help the company maintain its liquid assets during a time of turbulence and management turnover
Advantages of a Buy-Sell Agreement
During the transition of ownership, the buy-sell agreement maintains control and continuity. The agreement can also reduce the deceased owner’s estate tax liability. (Selling company shares during the owner’s lifetime is a taxable event, where the IRS frequently challenges those sales as disguised as a gift.)
How Buy-Sell Agreements Affect Valuation
Owners can select from two valuation assessment methods to determine the buy-out value of the partner’s share of the business:
- Setting an annual price agreed to by each owner for an annual valuation
- Tying the value of the company to an adjusted book value, earnings capitalization, or an approach incorporating those formulas
While the first method illustrated above assures a realistic valuation of the business at a set point in time, the annual price-setting needs to be kept up to date. If the methodology produces a relevant and reasonable price along with periodic and documented reviews, the company’s value can increase. Also, the potential financial consequences of the death of a partner can be mitigated.
Using the Insurance Option for “Buy-Out” Funding
The buy-sell agreement will specify how the “buy-out” will be funded when a triggering event, e.g., the death of a partner, occurs. The problem is, how can the buyer come up with the cash to buy a departing owner’s interest in the company?
Most businesses don’t have enough earnings to permit the surviving owner to pay out the value of the business to the deceased partner’s heirs. So, the most effective way is through a life insurance policy. The policy is based on the value assessment of each owner’s share in a business on a percentage basis.
Insurance options are permanent or term, lasting between 10 and 30 years and payable in the event of death and depending on the ages of the partners. As in normal term and permanent life insurance, insurance companies have limitations on what ages they allow partners to purchase a term insurance policy.
Individuals past age 65 won’t be eligible to purchase more than a 15-year policy for actuarial reasons. Most insurers do not provide any insurance coverage to anyone beyond age 82.
The Kinds of Buy-Sell Agreements
Business owners can choose from the following two types of buy-sell agreement life insurance plans:
1. Cross-purchase: Each business owner buys a life insurance policy for each of the other owners. When one owner dies, the survivors use the insurance proceeds to buy the deceased owner’s share of the business.
2. Entity purchase: This is a stock redemption plan. The business buys life insurance policies for each owner and pays the insurance premium. The business becomes the owner and beneficiary of the insurance policy. The company uses the policy proceeds to buy the owner’s interest from the deceased’s estate.
A buy-sell agreement protects you, your partners, and your business. Without the agreement, your company could be in the hands of the deceased partner’s family or someone else who knows little and cares less about the business.
An up-to-date (and periodically updated) buy-sell agreement is an exit strategy that helps protect you by setting ground rules for handling the ownership of shares when you or a partner leaves the business.
Your exit strategy depends on preserving the value of your business by tracking its growth in terms of financial and estate planning. When the time comes to act on the agreement, money will change hands, and you need to know where the money will come from. That’s where insurance-funded buy-backs come in.
How Quantive Can Help With the Big Picture
Maintaining and growing the value of your business and enjoying its proceeds after you retire requires a toolset and proactive exit planning. An insurance-funded buy-sell agreement is just one element of your big-picture exit plan. Get in touch with Quantive today to see how we can help your business situation.