Preparing for the Unexpected: The ins and outs of buy-sell agreements
You’ve worked hard to build your company, and you have a solid business plan in place to chart its growth. But do you have a plan that prepares for your death, disability, or retirement – or for that of your partner(s)? Rebounding from such an unforeseen event is not the time to wonder how you would raise the cash to buy out a deceased colleague, deal with a surviving spouse who inherits a partnership or shares of the firm, or provide for a disabled partner who still needs income but cannot work. To prepare properly, your company’s overall succession plan should contain a buy-sell agreement that gives clarity to its future disposition.
“A buy-sell agreement is drafted by an attorney and stipulates that, at death, retirement, disability, or other departure of a principal, to whom his or her share of the business must be sold and at what price,” explains Brent A. Field, LIC, senior advanced planning advisor at Comerica Bank.
By answering these questions up front, Field says a buy-sell agreement can help mitigate conflict, speed up the transition, and make sure that the business continues without the loss of revenue, assets, or clients. Buy-sell agreements also give banks confidence in the knowledge that a company’s future management has been pre-approved and is not in limbo. “Banks feel more comfortable when there’s a buy-sell agreement in place because they know that there’s a plan,” Field says.
Considering the substantial value of most middle market companies, one of the first questions to consider when drawing up a buy-sell agreement is how to fund it. Even with only two partners and a valuation of $1 million, scraping up $500,000 on short notice to buy out a deceased partner’s position can be devastating to cash flow.
Field says there are generally three methods of funding a buy-sell agreement: write a check, which is not preferred because it may require liquidation of valuable assets; borrow the money, which increases debt and can impair the credit rating; or purchase an insurance policy that pays out at the time of the event. He says the “term life” insurance option is one of the most popular. “If I need to set aside half a million dollars, I can transfer that risk to the insurance company for a relatively small premium,” he says.
Selecting the appropriate buy-sell strategy depends largely on the size of the business. In a two-person partnership, a “cross purchase” is used where each person buys a life insurance policy on the other, with each being the other’s beneficiary. A larger organization may construct an “entity purchase,” in which the company buys the policy and receives the proceeds, which are then paid out to the insured’s estate in return for their shares. A “wait and see” strategy, the least common, is often used when a company’s valuation has not been determined or when a tax situation is unclear.
Field says many succession plans ignore the prospect of a principal becoming disabled. “What happens if I have a stroke and I can’t work 40 hours a week, but I still need my paycheck?” he says. “Disability income insurance inside a buy-sell agreement is critical to take care of that disabled partner so that there isn’t cash flow pressure on the business to keep him on the payroll. The income that he was getting would be re-directed to the person who takes his place.” An additional life insurance policy to eventually purchase that person’s interest in the company is also recommended.
A buy-sell agreement is only as effective as the value that has been placed on the organization. Valuation is a critical factor in determining the cost of an owner’s share of the business, and without one the owner may not realize the true market value of his or her stock in the event of a death, divorce, or sale of the business. Setting a realistic value also reduces the likelihood of being challenged by the IRS. “The IRS is going to want to know the value of the business in my estate,” Field says. “If you don’t determine a value for the business, the IRS will help determine it for you, and that’s not what you want to happen.”
To further discuss buy-sell agreements, Brent Field can be reached at 248.645.4101 or firstname.lastname@example.org.