How a properly funded Buy-Sell Agreement can help a business survive the loss of an owner
Even if your business is positioned for success, partnerships and corporations may not be prepared for the financial consequences of the death of a owner or co-owner. As well as causing hardship for the deceased's family, it can upset the operation of the business, reduce its value or threaten its very existence.
If a co-owner dies, his or her business interest will generally pass to the heirs (such as a spouse).
Suddenly, the business has new co-owners who may not be qualified to participate. Or they may want to sell their share to cover expenses and estate taxes, and that could mean introducing a third party purchaser who does not share the business vision.
The resulting uncertainty can cause customers to defect, employees to leave, suppliers to withhold credit and lenders to call in loans!
Generally, the best solution is for the surviving owners to buy-out the heirs, retain 100% ownership and carry on business as usual.
This requires advance planning, and a good planning tool is a Buy-Sell Agreement.
A Buy-Sell Agreement is a written agreement between the co-owners that should one of them die, the others are obligated to buy his or her shares, and the estate is obligated to sell.
It also specifies a value for the shares and the method and conditions of payment. This eliminates the unknowns and provides benefits to all parties. The deceased's heirs receive a timely cash payment of the full market value. The surviving owners retain full control, and the business continues uninterrupted.
Naturally, a Buy-Sell Agreement only works if the surviving owners are able to pay for the shares. There are several ways to arrange this, some more attractive than others.
Pay cash from business earnings
This is the simplest method, but earnings may already be depressed, and cash payments could deprive the business of needed capital.
Sell business assets
This may realize less than full value in a poorly timed distress sale. What's more, selling assets can reduce the company's earning power and market value of the shares, and incur a selling cost and taxes, which adds to the total outlay.
Borrow the funds
This assumes that the business will have a good credit rating when it's needed. And remember that loan payments can add up and put a strain on much-needed cash flow.
Issue a promissory note
The surviving owners could give the estate a written promise to pay for the shares at a later date, but this doesn't give the heirs immediate cash they may urgently need. And again, paying for the note can strain cash flow.
Use life insurance
One of the most cost effective ways to fund a Buy-Sell Agreement is with tax-exempt life insurance on the life of each business owner. If one owner dies, the policy provides instant cash in the form of a tax-free death benefit. The cost is the annual insurance premium – about 1-5% of the purchase price each year.
Renewable Term Insurance is the most economical option over the short-term, but owners should consider a more permanent solution – such as Universal Life – when protection is expected to extend over a longer time frame, or if they want to create a supplemental compensation structure for the insured individuals.
As well as low-cost funding, life insurance offers a flexible structure to meet specific needs and minimize tax consequences.
- Individually-owned criss-cross buy-out – Each owner buys a life insurance policy on the lives of the other owners. When one dies, the surviving owners receive the death benefit and use it to buy the shares at fair market value.
- Corporate-owned criss-cross buy-out – The corporation buys a life insurance policy on all owners. When one dies, the surviving owners acquire the shares and issue a promissory note to pay fair market value on a future date. The corporation receives the death benefit and gives the surviving owners capital dividends to repay the promissory note.
- Corporate-owned share redemption – The corporation buys a multi-life insurance policy on all owners. When one dies, the corporation receives the death benefit and uses it to redeem the shares at fair market value.
A FUNDED Buy-Sell Agreement can also insure against a co-owner's disability, critical illness and retirement.
