Why You Need a Buy-Sell Agreement

Key Takeaways:

• A buy-sell agreement is a legal contract between co-owners of a business that sets out what will happen with a co-owner’s equity if he or she dies.
• Buy-sell agreements can be funded in several ways, including by borrowing money or through life insurance.
• Two main types of buy-sell agreements exist, along with a third, hybrid-type option.

If you’re a co-owner of a business and were to die, what would happen to your equity in your business?

If you have a partner and he or she were to die, would you want to be in business with that person’s spouse—or children?

If you sell part of your company to a private equity firm and then die sometime afterward, how can you be sure your loved ones and heirs won’t be cheated if that private equity firm attempts to buy them out??

As a business owner, it’s time to ask yourself these tough questions—or revisit them if you haven’t thought about them in years. The fact is, without proper planning, the sudden death of a co-owner can have serious financial consequences. It can, for example:

• Leave the family of the deceased co-owner without a major source of income
• Result in a lawsuit over acquiring the deceased co-owner’s share of the business
• Significantly hurt the ongoing business’s financial health

The good news: There’s a solution—called a buy-sell agreement—that can help avoid all of these negative outcomes. By having this agreement in place, you can be more confident that the uncertainties concerning your business after your death or the death of a business partner will be addressed as you would want them to be.?

How a buy-sell works

A buy-sell agreement is a legal contract between co-owners of a business, or between the business and the co-owners. It sets out what will happen with a co-owner’s equity if he or she dies—guaranteeing a buyer and guaranteeing a price. Buy-sell agreements can also deal with situations in which a co-owner is forced to leave a business or chooses to exit.?

A critical element of a buy-sell agreement is the approach used to value a business. The aim is to avoid any litigation over what the equity is truly worth. There are two basic approaches:

• Formulaic. A formula to value the company is used, such as a multiple of earnings. However, the formula used should likely be modified as circumstances change (such as when a business grows or adds new product lines).?
• Process. A methodology is used to determine the value of the business. For example, a valuation expert can be called in periodically to determine how much the equity is worth.

Funding a buy-sell agreement

Buy-sell agreements must be funded in order to work, and there are several ways to fund them. For example:

• Cash flow. This involves using money generated by the business to purchase the equity of a deceased co-owner. This approach lacks certainty for all involved because it requires the business to have enough cash flow at the time of death to buy out that equity—which may or may not be the case.?
• Borrowing. This approach involves taking a loan to pay for the deceased co-owner’s equity. It can be problematic because it depends so much on the financial position of the business or the surviving co-owner, as well as on a lender’s willingness to lend.?
• Sinking fund. Here, money is put away over time into a fund to eventually buy the equity of the deceased partner. One complication with this approach is determining just how much to put into the sinking fund. Fail to put in enough before a co-owner dies and there won’t be adequate cash to buy out the equity. Put in too much and you’ve essentially held on to money that could have been used to grow the business. In addition, money in a sinking fund could be exposed to a company’s creditors.?
• Life insurance. Using life insurance is usually the most common approach because it provides a guarantee that the other approaches do not, in the form of the policy’s death benefit. As a result, the estate of the deceased co-owner can be paid for the equity without any complications. Expected money is available when it is most needed due to the life insurance proceeds.

Three types of buy-sell agreements

There are two principal types of buy-sell agreements, and a third version that combines elements of the other two. Here’s how they work.

Type #1: Cross-purchase plan

Each co-owner will buy the equity from the estate of another co-owner based on the agreed-upon terms. This approach can be very effective for businesses with relatively few co-owners. Usually, each co-owner will have life insurance policies on the other co-owners under this type of plan (see Exhibit 4).?

These are the primary steps with a cross-purchase plan:

1. Each co-owner pays the premiums on the life insurance policies of the other co-owners.?
2. When a co-owner dies, the surviving co-owners receive the proceeds from the life insurance policy.
3. The proceeds are used to purchase the deceased co-owner’s share of the business.

Advantage: If the business is later sold by the remaining partners, they will have increased their basis in the business by using a cross-purchase plan—saving them taxes when they sell.?

Warning: Cross-purchase plans often are too unwieldy when there are many co-owners, because it can become difficult to determine who will buy what percentage of the equity of the deceased co-owner. It also often becomes complicated and inefficient to fund this arrangement. For example, it may be very expensive to have multiple life insurance policies on all the various co-owners. That said, there are some variations of cross-purchase plans that address these concerns—such as a trusteed cross-purchase plan incorporating a trust or use of certain partnerships. The addition of the trust regularly avoids the need for multiple life insurance policies, thereby reducing costs.

Type #2: Entity redemption plan

In this case, the business entity—not the co-owners—takes out the life insurance policies and pays the premiums. When a co-owner dies, the company can purchase his or her equity with the proceeds from the life insurance policy. This arrangement tends to work well when there are a large number of co-owners, as it is usually less complex than a cross-purchase arrangement (see Exhibit 5).

This type of plan unfolds along these steps:

1. The business pays the premiums on the life insurance policies on each co-owner.?
2. When a co-owner dies, the business receives the proceeds from the life insurance policy.
3. The proceeds are used to purchase the deceased co-owner’s share of the business.

Type #3: Hybrid plan

With a hybrid plan, the business usually has the first option to purchase the equity of the deceased co-owner. If the business chooses not to buy the equity—due to tax-related considerations, for example—the co-owners have the option to do so. A hybrid plan is more complex than the other two approaches (see Exhibit 6), but it provides greater flexibility in structuring the purchase of the equity from the deceased co-owner’s estate.

These are the major steps with a hybrid plan:?

1. The co-owners purchase (and are the owners and beneficiaries of) the insurance policies on all the shareholders.?
2. Upon the death of a shareholder, the business has the first right of refusal to buy the equity of the deceased partner. If the business chooses to exercise that right, it buys the shares and brings them back into the business directly.
3. If the business passes, the surviving shareholders then get the right to purchase the equity directly. If they exercise the right, they then buy the deceased’s shares directly and own them personally.

Taking action

Conceptually, buy-sell agreements are pretty straightforward. But clearly, there are important nuances and complex issues to consider when determining the best type of buy-sell as well as the right funding mechanism for your needs. Depending on various factors—such as the number of co-owners in a business—things can get complicated fast. With that in mind, consider working with a financial or legal professional you trust who is also well-versed in the area of buy-sell agreements.?

VFO Inner Circle Special Report?

By Russ Alan Prince and John J. Bowen Jr.

? Copyright 2019 by AES Nation, LLC. All rights reserved.

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