Buy-Sell Agreements
How smart business owners take good care of their business for the long-term
Key Takeaways
The majority of business owners don’t have succession plans in place.
A buy-sell agreement stipulates how a partner's share of a business may be reassigned if that partner dies, becomes disabled or otherwise leaves the business.
Key person life insurance (aka Key Man) covers the cost of finding a replacement for the loss of a vital owner of team member.
When it comes to succession planning, don’t be a do-it-yourselfer.
By Robert Pyle
Business owners are highly driven people. But, a downside to that entrepreneurial passion is that they spend so much time IN their businesses that they have no time to spend ON their businesses. Succession planning is one critical area that often gets overlooked.
According to PWC’s 2019 family business survey, three out of four business owners don’t have documented succession plans in place. I suspect that number is even higher. Even more alarming: over half of U.S. business owners today are over age 50.
If you don’t have a succession plan in place—or if it’s been years since you updated your plan—don’t keep procrastinating. The world moves fast and doesn’t wait around for you to get all your succession planning ducks in a row. Changes in ownership happen every day in all types of businesses for all types of reasons: Death, retirement, disability, divorce, voluntary and involuntary termination of employment; lawsuits, financial and economic setbacks, bankruptcy, selling and gifting interests, just to name a few. These disruptions often result in: Collateral damage to customer, supplier, banking and employee relationships as well as to long term company goodwill.
Fortunately, most of the painful issues above can be avoided by having a well drafted “buy-sell agreement” in place right from Day One. That’s when all of the owners are still in the “honeymoon” stage and when relations are most amicable. However, it is never too late to put a buy-sell agreement in place. Honesty and open communication are the key to making by-sell agreements work.
What is a buy-sell agreement?
Also known as a buyout agreement, a business will or a business prenup, a buy-sell agreement is a legally binding contract that stipulates how a partner's share of a business may be reassigned if that partner dies, becomes disabled or otherwise leaves the business. Most often, the buy-sell agreement stipulates that the remaining shares of the business should be sold to the other partners or to the partnership itself.
Buy-sell agreements are typically funded by life insurance that protect the business if an owner dies. That way the owner’s spouse or family doesn’t have to step in and take over the business—something they likely have no experience running. If you’re an owner and you don’t have other owners, a mature child or close relative capable of running your business, then a buy-sell agreement can be used to set up a formal agreement to sell the company to a competitor or to a private equity group at a predetermined price when you leave.
Buy-sell agreements can take many forms (more on that in a minute). What they have in common is that owner(s) agree well in advance to the terms of a potential business at some point in the future. This way, an owner’s family doesn’t have to sell under duress should something unfortunate happened to the owner.
Getting started: Document everything!
One of the first things we advise business owners to do after they start working with us is to document every bill that comes in, as well as how they received the bill (email or paper, etc.), how they paid it (check, bill pay or credit card) and when that service or software contract ends. As an owner, you need to document how all the money flows through your accounts and how you pay all your bills for your house and other personal expenses.
Very important: If you own a sole proprietorship, make sure your spouse knows your master password. If you’re part of a partnership or multi-owner business, make that at least one of the other principals knows your master password. All businesses, regardless of size, need a Plan B in case something happens to the one person who pays all the bills and who understands all the contracts that keep the business running. Also, it’s very important to update all your documentation every year or so--it’s not a one-and-done exercise.
Before you get started, seek out attorneys or CPAs who specialize in succession planning or a business broker who might know somebody who has expertise in succession planning. Some CPAs even have an ABV® credential (Accredited in Business Valuation).
Key person life insurance
The death of a key employee or team member can potentially sink your business if you’re not protected. Key person life insurance (aka Key Man life insurance) provides funds for a business when a key person dies. This type of policy helps address the financial losses that can occur when a key person in the business passes away and money from the policy can be used to find a replacement for the key person or to train someone to take the place of the key person who died or otherwise left the business.
Under most plans, the company purchases a life insurance policy on the key people and the company pays the premiums on the policy. If the key person passes away, then the proceeds from the policy are payable to the company. Determining the amount of life insurance to purchase can be challenging. You could use the cost of replacement, a multiple of compensation or a contribution to profits method. Again, don’t try to do this yourself. Consult with a life insurance specialist that works with business owners. If you would like a referral to professionals who can help, please let us know.
Don’t think you’re big enough for a Buy Sell Agreement? Think again
You may think your business is too young or too small to need a sophisticated transition agreement. Just understand this: If you’re business is too large for your spouse or outside family members to take over, then you need a buy-sell agreement. If the business is your family’s only source of income, then you need a buy-sell agreement. If your business is potentially “sellable”—i.e. it has recurring revenue in the form of contracts or agreements with customers/clients that pay you on a regular basis--you need a buy-sell agreement.
Most common types of buy-sell agreements
1. Cross Purchase Agreement. Each co-owner agrees to purchase the equity from the estate of the co-owner that passed away. The sales price is agreed upon in advance and life insurance is used to fund this type of plan. Each co-owner has separate polices on each of the other co-owners and they each pay the premiums.
2. Entity redemption arrangement. In this type of agreement, the business (not the individual owners) takes out life insurance policies on the co-owners and the business pays the premiums. When a co-owner passes away, the company can then purchase that owner’s equity with the life insurance proceeds.
3. Hybrid plan. Under this plan, the business has the first option to purchase the equity of the co-owner that passed away. If the business does not elect to purchase the late co-owner’s equity, then the remaining co-owners have the option of purchasing the deceased owner’s equity.
If you don’t have a child or key employee(s) to assume ownership of the business, you can sell to a business consolidator in your niche. You could also have an agreement with a competitor to buy your business at a pre-determined price. There are many other types of buy-sell agreements which I’ll discuss in a future article. Regardless of which structure you choose, make sure you have something in the agreement ties the sales price to the business’s revenue or profit. That way the predetermined sales price can be adjusted fairly if the business grows (or declines) substantially between the time the agreement was made and when it is actually sold.
Update regularly
Like your estate plan, you also want to have a business valuation every three or four years. In addition to CPAs, check with the trade associations or professional societies in your business. They can be great resources for finding business valuation professionals that specialize in your niche.
Cautionary tale
If selling to an outside owner or a competitor, you may get a nice offer for your business in the form of an installment sale rather than the one-time purchase. A typical scenario for an installment sale of a $1 million business is 30 percent ($300,000) paid to the owner upon closing and the remaining $700,000 paid over five years ($140,000, plus interest). If you’re the owner, you could potentially pay less in taxes when you close and theoretically earn more money when the interest payments are factored in (please consult with your tax professional). However, there is also more risk involved in an installment sale than a one-time transaction. The buyer could run into hard times, the economy could go in the tank, and the new owner might be unable to make the payments to you each year, leaving you out in the cold.
You should thoroughly investigate you buyer and to make sure they are qualified. This could involve an expensive background check. As the seller, you will need a larger emergency fund on hand in case the buyer is late on the payments or worse, defaults. You want to ensure there is a good transition after the sale and that your clients are comfortable with the new owner. If not, there is always an outside chance that you will have to take over the business and go back to work.
Conclusion
Succession planning can get overwhelming quickly for time-pressed business owners. It takes coordination with the other owners and with specialized legal, accounting and financial advisors to make sure you’re doing everything right. Then you need to check every few years to make sure the agreement is still valid and reflective of the business today. If nothing else, avoid the two most common but dangerous mistakes that business owners make: Procrastinating and being a do-it-yourselfer. You’ve worked too hard to build your business to throw your employees and family into a bad situation. If you or someone close to you has concerns about an eventual business transition, please don’t hesitate to contact me.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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