Running a business is all about taking one thing at a time. From addressing the ongoing needs of your customers, colleagues and co-workers to supply chain fluctuations, every day brings a new challenge. Given the highly dynamic nature of business management, it can be difficult to plan ahead for tomorrow — never mind two, 10 or 20 years from now.
But if the pandemic taught the world anything, it’s just how quickly things can change. The day-to-day unknowns are one thing, but the unknowns that can throw you for a loop are those that affect the survival of your business, such as if a partner becomes seriously ill or were to die suddenly. These worst-case scenarios came to fruition during COVID, when otherwise healthy individuals became incapacitated or passed away, leaving the surviving owner with an unclear path of what comes next.
Buy sell agreements help a business owner — or, more specifically, business owners — address the unexpected. This article will help you get a better appreciation and understanding of how buy sell agreements work, the types that exist and where life insurance enters the equation.
What is a buy sell agreement?
A buy sell agreement is a fairly straightforward planning strategy that determines what becomes of the business if someone in management passes away, becomes incapacitated or simply doesn’t want to be involved in the day-to-day operations of the business anymore. In short, they no longer want to be an owner. If any of those events come to pass, one party buys and the other sells their ownership interest.
There are a number of events that can lead to a buy sell situation beyond adverse health events or a change of heart. For example, if a business partner is married, they may go through a divorce. Splitting from their spouse may affect where they live or compromise the business’ longevity if it’s family-owned.
Another scenario that makes a buy sell agreement worthwhile is if some kind of malfeasance is discovered, such as fraud, internal theft or racketeering. Such activity would require them to be stripped of their title, if for no other reason than the legal implications.
A buy sell agreement addresses these and many other worst-case scenarios —including bankruptcy — as well as inevitable circumstances, like retirement or a change in the valuation of the business.
How does a buy sell agreement work?
Precisely how a buy sell agreement works and is arranged largely depends on the type of agreement that’s in place, the triggering event (e.g. deceased owner, voluntary departure of owner, divorce, etc.), and the structure of the business itself, such as a partnership, limited liability corporation (LLC) or traditional corporation.
For example, one kind of buy sell agreement is known as an entity purchase agreement. Entity purchase agreements — which are actually called liquidations of interest among partnerships and stock redemption agreements for corporations —are arrangements where the business itself buys the business interest of another owner should a triggering event occur, such as an untimely death. Everyone must come to an agreement on what the buy out price will be.
Another kind of buy sell agreement is called a cross purchase agreement. These arrangements are primarily for businesses that operate as corporations and entail each shareholder taking out life insurance policies on their fellow shareholders. What each life insurance policy is worth — meaning what its face value is — largely depends upon each business owner’s ownership interest. The life insurance proceeds are used to buy the ownership interest from whomever the beneficiary of the policy is upon that owner’s death.
Other common buy sell agreement structures include one-way buy sell plans and wait-and-see buy sell plans. The former are mainly used by sole proprietorships and the latter are largely leveraged by partnerships.
Regardless of how you decide to structure a buy sell agreement — which may be best determined by consulting with a lawyer — they should address a few key areas. These include:
- A method that determines how the business will be valued (i.e. standard of value).
- Complete listing of valuation adjustments and/or discounts.
- Triggering events that necessitate a buyout taking place.
- Terms of the buyout.
- Date in which the business will be appraised.
- Appraisal deadline.
Where does life insurance come into play?
Buy sell agreements can be funded a number of different ways, but one of the most common methods is through life insurance. How life insurance proceeds are utilized hinges on the type of buy sell agreement that’s in place. For example, with a cross purchase plan, each business owner buys or takes out a life insurance policy on their fellow co-owners. If one of the co-owners passes away, the resulting death benefit is used to buy up the shares of the owner who died.
With an entity purchase agreement, however, life insurance works a bit differently and isn’t quite as straightforward. Instead of each individual business owner buying a life insurance policy on each of their co-owners, the business takes out life insurance policies on each owner. When a triggering event takes place, the surviving owner(s) give the deceased owner’s shares to their beneficiaries, such as their children or spouse. The business then uses the death benefit to buy the interest from the deceased owner’s beneficiaries or their estate.
As previously noted, life insurance is only one kind of buy sell agreement funding method. Perhaps the most straightforward one is with a business owner’s own personal funds. However, going this route can be difficult, given that few people have the kind of cash on hand that would enable them to set aside funds that are necessary for a buy sell agreement. Besides, what money they do have available is often spent on the business’s day-to-day needs, never mind their own.
Another method is through the business’ ongoing cash flows. But this can be a risky funding option because if a business owner passes away, the cash flow the company typically generates may diminish. This is especially true if the deceased owner played a key role in terms of bringing in revenue.
An additional way to pay for a buy sell agreement is by borrowing the money from a lender. This solution makes sense in one respect because it resolves any issues related to not having enough liquidity. But the problem here is you have to pay the loan back with interest. And with interest rates rising — for the first time since 2018, in fact — you can wind up spending a lot more than you borrowed just from the interest alone.
This is why life insurance premium financing makes so much sense as a buy sell agreement funding solution. First and foremost, premium financing allows individuals and businesses to pay the premiums of high cash value life insurance policies. The beauty of this strategy is the cash value component. In addition to the fact that it can be used as collateral for the loan, cash value means the amount that’s owed on the principal can often be paid off through the policy’s earnings.
For more information on life insurance premium financing and how it can be used to service buy sell agreements, business succession and so much more, please contact Global Financial Distributors today.