Business Protection Strategies

Buy Sell Agreements

If you are or have ever been in business with a partner(s), then you know that your business relationship is very much like a marriage. Although in some marriages, a couple will enter into a prenuptial agreement to protect one or both partner’s assets from a marital breakup, business partners often overlook the potential difficulties from the failure to pre-plan how to carry out and fund the process of when a business owner leaves the company due to an unresolvable dispute, a disability, death, or even personal bankruptcy . If your spouse dies, you generally know how their share of the marital assets will be handled. But if your business partner dies, becomes disabled, or even gets divorced, do you know who inherits their ownership interests, or whether you will now be making business decisions jointly with your former business partner’s spouse, your business partner’s ex-spouse or children?

A properly documented buy-sell agreement typically resolves the potential issue for the transfer of ownership interests in advance of the need, by addressing those concerns  as well as providing the funding mechanism that is required to buy out the ownership interests concerned.

Buy-Sell Agreements are typically funded with life insurance and disability buy-out insurance on each of the principal business owners. In the event of an owner’s death, the surviving owners can utilize the death benefit proceeds to buy out the deceased owner’s interest. Similarly, disability buy-out insurance can serve the same purpose if an owner is no longer able to remain and function within the business in accordance with the terms of their agreement. Permanent insurance policies can often provide a source of cash by borrowing against cash values, in order to provide funding in the event a partner is not deceased or disabled but must be bought out for other reasons.

Various Types of Buy-Out Agreements and their funding mechanisms:

In a “Cross Purchase Buy-Sell Agreement” – the respective owners of a business would purchase individual life insurance policies on each of the other owners. For example, if A, B, and C are owners of a business, A would own a policy on B and C, B would own policies on A and C, and C would own policies on A and B for a total of six policies. Conceivably, if there were 8 partners, you would require fifty six policies (n squared minus n), however at that point, it probably would make more sense to consider a trust (trusteed buy-sell arrangement), partnership or other legal entity to own the policies so that only one policy per owner is needed. Regarding the latter, if a such an entity is used to own all the policies, the document must assure that the various owners do not have incidents of ownership in their own policies so as to avoid unwanted tax consequences.

An “Entity” buy-out arrangement is another type of agreement where the business is required to purchase the departing owner’s interest in the business, and the business will utilize life insurance policies on each of the owners in order to fund the agreement when needed. With an “Entity” arrangement, only one policy per owner is purchased, as the proceeds are payable to the legal entity.

A “wait and see” buy-sell agreement is a hybrid type plan where the funding mechanism to purchase a deceased owner’s shares is the same as in a cross-purchase agreement. In other words, each partner owns a life insurance policy on the remaining partners. The difference is that upon a deceased owner’s death, the company has first “rights” to buy out the deceased owner’s shares and if the company refuses, the remaining partners may then step in to purchase the shares. If the remaining partners’ do not want to purchase the shares, then the company is contractually obligated to do so. Typically, if it is the entity that makes the share purchase, the owners of the business will make loans to the company to enable the funding, or alternatively the separate owners can each make capital contributions to the business so that the entity will have the necessary funds to complete the buy-out of the deceased owner’s shares. The purpose of all this is to enable a mechanism where the deceased partner’s beneficiaries receive the most favorable price for their inheritance by having the company and/or the remaining partners, together or separately, agree to purchase the available shares.

In summary, a well-documented and funded Buy-Sell Agreement is an important part of a company’s strategy to secure stability and continuity should the probability of disputes, disability or death cause a severe disruption to a company’s ongoing profitability and survival.