While businesses need many things to operate effectively, a buy-sell agreement should be near the top of the list. A buy-sell agreement sets guidelines for transferring a business interest when a so-called qualifying event takes place – an owner’s death, disability, retirement, divorce, involuntary withdrawal or voluntary withdrawal from the business. The agreement typically includes the purchase price and specifies to whom owners can transfer their business interest – other owners, children, spouses, other family members or outsiders – and when.
Generally, buy-sell agreements come in three types:
- Cross purchase agreement. The remaining owners agree to buy each other’s business interests if a qualifying event occurs. These agreements are more typical when there are only two owners.
- Redemption agreement. The company purchases the departing owner’s business interest.
- Hybrid agreement. Either the remaining owners or the business buy the business interest, allowing the parties to determine the best strategy when the qualifying event occurs. Sometimes both the remaining owners and the company buy the business interest.
To fully understand what a buy-sell agreement can and should do, business owners should ask their financial planner to take them through a matrix of events that could trigger the agreement. Most owners have boilerplate agreements drafted when they formed the business, but those agreements don’t usually address anything beyond what happens if an owner dies.”
So which type of agreement is most advantageous? The answer depends on factors such as the size of the company, the industry in which it operates, the number of owners and the tax laws in effect at the time of the qualifying event. Since it’s impossible to predict what the future holds in terms of taxes and owners’ personal situations, a hybrid agreement generally offers owners the most flexibility.
Keep It Current
Even the best buy-sell agreement can fail if it’s outdated. Business owners should review the agreement with their lawyer, accountant and other financial advisors regularly to make sure it still meets their needs.
One of the biggest problems with outdated agreements is the price to be paid for a departing owner’s business interest. Many agreements state a value that hasn’t been reviewed since the document was drafted. It’s extremely important to periodically review how you arrived at the sale price so you aren’t undervaluing—or even overvaluing—the business.
It may be best to use a valuation determined by an independent appraisal or a formula based on book value, revenue or some similar benchmark. The most appropriate method will vary by industry, and even then adjustments in the formula may be needed company-by-company.
Pay It Forward
By providing tax-free dollars to pay for a buyout, life insurance is traditionally the most economical way to fund a buy-sell agreement in the event of a business owner’s death. A cross-purchase agreement would allow business owners to buy insurance on each other’s lives. With a redemption agreement, the company purchases insurance on each owner.
However, many business owners make the mistake of funding the agreement with term insurance. When that insurance expires and the business is still operating, they then have to buy permanent insurance at a higher cost.
Life insurance can also be useful in other situations, and it’s possible to use the cash value feature of permanent life insurance to accumulate funds tax-deferred for a living buyout. For instance, for some business owners, the insurance needed for a purchase at death is funded with the goal of accumulating a targeted cash value at age 65, which is large enough to fund a potential retirement buyout. This is accomplished with policy loans, withdrawals, or even by surrendering the policy. The owner’s business objectives, health and overall planning objectives will dictate how the policy is funded.
There are other methods to fund a buy-sell agreement, such as borrowing money from a bank or using the company’s current cash flow. Not only are these strategies generally less popular, they are more expensive. Plus, when you lose a key business owner who was active in operating the business, borrowing money or depending on company resources generally isn’t the best idea.
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