As a business owner, your focus is on daily operations and growing the business. Consequently it can be difficult to carve out time to consider long-term issues and contingency planning such as ensuring the continuity of the business should anything happen to you or a partner. For most business owners, such planning requires establishing a Buy-Sell Agreement.
To help you determine if such an agreement is right for your business, it’s important to understand what it is, how it works, and the funding methods available.
What Is a Buy-Sell Agreement?
A Buy-Sell Agreement ensures business continuity if an owner or partner becomes disabled, decides to retire, or passes away unexpectedly. It outlines the parties involved in the agreement, describes the events that trigger a transfer of ownership, and lays out an agreed-upon value of the business. Having a Buy-Sell Agreement in place helps avoid rushed decisions during what can be an extremely stressful time when a key manager is lost temporarily or permanently. It also provides the funding mechanism that compensates the seller and creates purchasing capital for the buyer.
Structuring the Agreement
There are several ways to construct a buy-sell agreement. The best choice will depend on your company’s structure and ownership:
- Cross purchase: A business partner agrees to purchase the business from the other partner, the owner or the owner’s family.
- Entity purchase: The business entity agrees to purchase the business from the owner or the owner’s family.
- Wait-and-see: The buyer of the business is allowed to remain unspecified, and a plan is put in place to decide on a buyer at the time of a triggering event (e.g., retirement, disability, death).
After a triggering event occurs, either the business entity or another party will begin the process of purchasing all or a portion of the business, based upon the valuation described in the agreement.
It’s mandatory to include funding details in a Buy-Sell Agreement to ensure a successful transfer and to keep the business running smoothly. Common funding methods include cash or assets of the business, a loan with installment payments, an employee stock ownership plan (ESOP), or the common form of life insurance.
Life and Disability Insurance
Insurance provides liquidity to help the business during a challenging situation or to purchase the business from a partner or grieving family. Depending on the structure of the company and the type of Buy-Sell Agreement, the business may be able to pay the premium, or bonuses may be given to those policy owners who pay the premiums.
- In a cross-purchase agreement, all business owners will purchase, own, and be the beneficiary of a life insurance policy insuring each of the other business owners. This type of agreement may not appeal to a business that has many owners, as it requires several policies to be purchased. For example, if there are 4 business owners, a total of 12 insurance policies would be needed.
- With an entity purchase agreement, the insurance policy is usually owned by the business. Even with multiple owners, only one policy per owner is needed.
- In wait-and-see agreements, the policy ownership and beneficiary structures vary, depending on the type of the agreement that is ultimately put in place.
ESOPs (Employee Stock Ownership Plans)
When the plan is to sell a business to employees, an ESOP can be established to help provide a source of funds. An ESOP requires specialized administration to navigate the complexity of the agreement and to comply with applicable rules and regulations. Well-suited companies for an ESOP generally fit within the following guidelines:
- Privately held, profitable C or S corporation
- More than 30 employees
- Value of at least $3 million
- Established management team and strong cash flow history
If your company is without a Buy-Sell Agreement, consult with an attorney and a tax advisor to develop a plan that best serves your needs. Fund the Agreement with the help of your financial advisor, preferably one with significant experience in insurance, business planning, and business succession work. Once the agreement is in place, be sure to review it every few years to ensure that it accommodates changes that may have occurred.