Buy-Sell Agreements- Why Business Owners Need Them

Buy-Sell Agreements- Why Business Owners Need Them

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Every Business Owner or Partner Will Eventually Either Retire, Die or Possibly Become Disabled.

When one of these life events occurs, the business should already be prepared to transition to new ownership whether it is to existing owners, children in the business, key employees or through a sale of the business. A Buy-Sell Agreement can provide an orderly roadmap as to how this will take place and under what terms it will occur. However, a Buy-Sell Agreement is only as good as its funding. If there is an agreement to have an owner bought-out and there is no mechanism for funding the buy-out, then all of the best-made plans will fail. Using Signature Guaranteed Universal Life insurance as a funding vehicle provides a guaranteed death benefit with the ability to Cash-Out the policy after 15, 20 and 25 years if the owner retires or is disabled and generally a tax-free death benefit that self-completes the buy-sell upon death.1

A Buy-Sell Agreement is a contractual agreement that restricts the transfer of shares in a business. Usually, Buy-Sell Agreements provide the business or other shareholders the option to purchase the business interest of any owner who dies, retires or becomes permanently disabled. Oftentimes the buyer is required to buy and the seller is required to sell under the agreement, and in other situations, it is set up so the other owners merely have the right of first refusal. In other cases, the remaining owners have the first right to buy shares of the existing partner and for any share they do not redeem, the company is required to purchase the remainder of the shares. In this way, each owner or their estate is restricted from selling shares to anyone other than the remaining owners of the company. It can also avoid the remaining owners being in business with the deceased owner’s family.

Valuing the Business

The Buy-Sell Agreement will also provide a mechanism for valuing the shares being sold. The Buy-Sell Agreement normally contains a formula for valuing shares or the owners regularly agree on a fixed price for the stock tendered. Methods used to compute the value include:

  • Book Value which takes assets minus liabilities from the most recent company balance sheet. Oftentimes, a multiple of book value is agreed upon which will provide a fair market value of the business interests.
  • Multiple of Earnings which reflects what the business is returning to its owners. A multiple of the earnings number is then used to approximate fair market value.
  • An appraisal which establishes the fair market value at the time of the buy-out. This method is often used when interests in family-owned businesses pass from one generation to the next as the IRS requires the use of current appraisals when the Buy-Sell is amongst family members.
  • Annual Valuation where the business owners meet each year and assign a value to the stock based on current values of the business.

Types of Buy-Sell Agreements

There are normally three ways to structure Buy-Sell Agreements:

Cross Purchase Buy-Sell

In a Cross Purchase Buy-Sell, the owners agree to buy out the existing owner based upon various triggering events such as death, disability, retirement, dissolution of the company, departure from the company or divorce (divorcing spouse must sell interest). This is normally accomplished by purchasing insurance on each other or by forming a partnership to own the insurance. Each owner will pay premiums on policies on each other and will be beneficiaries on the policy. One of the main advantages of a cross-purchase Buy-Sell is that the owners get a step up in basis on the stock purchased from the existing shareholder.

Stock Redemption Buy-Sell

In a stock redemption Buy-Sell Agreement, the company is required to purchase the existing shareholder’s stock. This is most often used when there are multiple owners where it would be impractical for the owners of each own policies on all of the other owners.

Hybrid Buy-Sell

A Hybrid Buy-Sell Agreement also known as a Wait and See Buy-Sell combines both the Cross Purchase Buy-Sell and the Stock Redemption Buy-Sell into one agreement whereby the individual owners have the first right to purchase the existing shareholder’s interests. Any interests the individual owners do not purchase, the Company is required to purchase.

In some situations, a Buy-Sell will be structured to offer a non-owner, non-family member who is a key employee the right of first refusal to purchase the business. In these instances, if proper planning has been done the purchase will have been funded with a life insurance policy on the owner that is held by the key employee.

Advantages of a Buy-Sell Agreement

  • Helps create a market for a closely held business
  • Assures continuation of businesses that owners worked hard to create
  • Establishes a purchase price for each owner’s interest in the business and if the agreement is between non-family members may be used to establish the value of the business for estate planning purposes
  • Restricts outsiders from obtaining an interest in the business or control of the business
  • Allows co-owners the ability to purchase the existing owner’s interest
  • Insurance death benefit provides estate liquidity and cash to beneficiaries not involved in the business
  • Cash value in an insurance policy helps provide a means of paying for interest if the owner becomes disabled, retires or leaves the business
  • Serves to avoid family disputes
  • Avoids disruption of the business after an owner’s death

Buy-Sell Agreements provide an efficient means of transferring a business interest upon the withdrawal,  death, disability or retirement of an owner.  An agreement without a means to pay for the stock does not help anyone. Life insurance is one of the most cost-efficient and tax efficient means to fund a Buy-Sell Agreement. Using a  Guaranteed Universal Life policy as a funding vehicle is a cost-effective way to guarantee a permanent death benefit will be there when it is needed.

 To determine whether a Buy-Sell is right for your company, consult your financial advisor. All concepts, strategies and products discussed in this literature may not be suitable for you and your company. Please consult your advisors to determine if a Buy-Sell Agreement is right for your specific circumstances.

Disadvantages of a Buy-Sell Agreement

  • The agreement must be funded to be effective
  • If insurance is used as the funding vehicle, premium payments need to be made to keep the policy in force

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