The lowdown on buy-sell agreementsOct 05, 2021
Many small business owners I’ve spoken with have given me a ho hum answer when I’ve asked if they know what a buy-sell agreement is, if they have one, and whether or not they have that agreement funded. Most business owners are concerned about running their businesses, and with their limited resources are hesitant to seek out an attorney for advice, fearing a large legal bill. I get it. I’m a business owner as well. So, here’s the nitty gritty why if you own a business, a buy-sell agreement is an imperative document to have if you are concerned with long-term viability of your business.
What the heck is a buy-sell agreement?
A buy-sell agreement is a legally binding contract that states what will happen to the business ownership interests should one of the owners die, become disabled, or retire. The buy-sell agreement is a key piece in business succession planning. Although they are widely used for businesses with multiple owners, they can also provide a blue print for an exit strategy for a company with an older owner who wants to sell to a younger owner or key employees who may want to take over, or to secure a buyer in the future, especially if it is unknown whether or not the children of the owner will take on the business. The provisions of the buy-sell agreement will spell out what has to be done when an owner retires, becomes disabled, or dies. The best time to decide what happens is when owners are in good health, but thinking about the possible “what ifs” that may throw a curveball in the future.
Three types of buy-sell agreements are commonly used, depending on the situation of the business, a cross-purchase agreement, an entity purchase agreement, and a hybrid of the two.
Here’s an example of the difference having a buy-sell agreement can make:
Company Layers, Inc. is comprised of two business owners, Lara and Meyer, each owning half of the company. Lara wants to leave the company and start her own. Meyer wants to stay and run the business. The company isn’t making much money, and they both have put a lot into it. They don’t have a buy-sell agreement. Now they have to figure out what to do next. Had they had a buy-sell agreement, then the agreement would dictate how Meyer could buy out Lara, and Lara would know how and when she was going to be paid for her half of the company.
Why it’s important to fund the buy-sell agreement
There are provisions in the buy-sell agreement that state how the departing owner is going to be paid. A going concern is the actual payment to that departing owner (or her/his estate) and where that cash is going to come from. Although it may not always be possible to cover all possible situations, it surely is important to fund the agreement for situations like death and disability. This is where life insurance comes into play to enforce the payment provisions in the contract because it provides the necessary cash needed without having to find or borrow the cash from other sources. The odds are really high that an owner could become disabled or die, so it makes sense to provide a means for an easier way to buy out those interests. Disability insurance is used to cover expenses when one owner becomes disabled. Additionally, insurance could also mean a significant difference for long-term retirement buyouts and savings.
Here are two situations that are vastly different because of the buy/sell agreement funding:
Company Blue has two owners with 50/50 ownership interests, Alex and Candy, who provide tech services to clients.
They have a buy sell agreement that states that should one of them retire, become disabled or die, the other has the option to buy the other out.
This past year, their company was valued at 1 million dollars, so each owner’s interest is $500,000.
Scenario One – Buy-Sell Agreement isn’t funded:
Alex suffers from a heart attack one day and dies. Candy wants to purchase Alex’s ownership interests from Alex’s estate. Since there is no life insurance policy, Candy has to go to the bank and apply for a mortgage or seek other sources to come up with the money, otherwise she’s in business with Alex’s heirs. If she doesn’t come up with the money, she may have to close the business in order to pay Alex’s heirs his interest.
Scenario Two – Buy-Sell Agreement is funded with life insurance:
Their agreement is funded with life insurance policies of 1 million dollars on each of them, with the other as the beneficiary. When Alex passes away, Candy is able to make a claim on the insurance policy and pay the $500,000 to Alex’s heirs using the death benefit. Candy is able to continue the business as a sole owner, or can offer any interest portion to another buyer after Alex’s heirs are paid.
To recap what a buy-sell agreement and benefits of funding with life insurance:
Buy- sell agreements stipulate how the business interests will be transferred.
- Life Insurance provides a source of cash for a lump sum payment to heirs
- Guarantees a buyer for the interest so heirs don’t have to worry about it
- Insurance proceeds are usually paid out pretty quickly
- Life insurance proceeds are usually tax free (depending on business structure)
- Provides market value for the business interest
- Peace of mind for all owners that business will continue
Granted, for the purposes of this post, I haven’t delved into the depths of what the provisions should say because every business is different, and that is a rabbit hole! There are a lot of different ways to write your buy-sell agreement and plenty of ways to fund it.
If you'd like to learn more, it's best to set up an appointment with me. Come talk to me – I’m not scary. I can help you write the agreement you need, and fund it the way that works best for you.
Are you ready to get your head out of the sand and take charge of your legal needs? Get empowered, because you know, knowledge is power. Let me help you!
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