Every successful business should have a succession plan. For small businesses, partnerships, and closely held corporations, a Buy Sell Agreement is essential for the smooth transition from the tragic and unexpected passing, or retiring owner.
What is a Buy Sell Agreement?
A Buy Sell Agreement is a contract to reallocate shares between a business owner and another party (usually another owner of the business, a key employee, the business itself, or other interested party) whereby the other party will purchase the share of the business upon a predetermined triggering event. This event could be an unexpected and tragic death of the owner, the retirement of the owner, or any other event in line with the owner’s exit strategy.
Questions to Ask When Before Structuring a Buy Sell Agreement
Assume you have a business partnership, and a family. Your business is established, and your children are grown with careers of their own.
What happens to the business in the event of a premature death?
What happens to your family in that scenario?
The business is heavily dependent upon you, and so is your family. Your business has provided good income for your family for years.
Without a Buy Sell Agreement, your share of the business typically passes to your estate, or heirs.
Does your family have the skills to replace you in your position?
Do they even want to take on any responsibility with the business?
Is that what is best for the business?
What about your business partners?
Would they want to purchase your remaining shares from your family? How would they fund that?
These are a lot of questions. And anyone who has worked hard to build a business and care for their family owes it to themselves to ask these questions.
Many partnerships have the informal agreement that the remaining partners will purchase the shares from the family.
But how will they fund that?
Will they buy the shares on some yearly installment plan? Is that what you would want for your family?
What if the business suffers due to you not being their, and the partners can no longer make payments…or the value of the business decreases over time?
Would they take out a loan? What if they can’t get a loan due to a credit crunch or other unforeseen circumstance?
Many people would prefer their family receive a lump sum for the remaining shares in the business at the current market value, and be left to grieve.
What if the scenario was changed and it was your business partner who tragically passed?
Would you want your partner’s family involved in the management of the business?
If you were to purchase the remaining shares from your deceased business partner’s family…how would you fund that purchase?
This will be a difficult time for everyone….a time of transition for the business as well. Would you want to get a loan?
Would you have cash on hand to buy the shares outright?
Or would you prefer to have access to immediate, tax free cash paid from a life insurance company to provide to your deceased business partner’s grieving family?
Buy Sell Agreement Contracts
As stated before, many Buy Sell Agreements are simple informal arrangements between business partners who have worked well together for years and whose interests are aligned.
A lot can change over the years.
And a lot more can change once the dynamics are changed. Dynamics such as family members now inheriting buisness interests….market dynamics….economic cycles.
With dynamics as fluid as they are, it is in everyone’s best interests to have a formal, written
Buy Sell Agreement drafted by an attorney.
This contract will state the terms under which shares will be reallocated and what those triggering events could be that would mandate the reallocation. Many of these triggering events will cause a lot of stress, emotions, and conflicting self interests. As such, it is prudent to all owners, their families, and the business to contractually agree to the reallocation of shares due to triggering events in advance.
Funding a Buy Sell Agreement
There are three primary methods of funding when a Buy Sell Agreement is triggered. Each method has its pros and cons.
- Self Funding – The remaining business owner(s) use cash on hand or purchase the reallocated shares on a predetermined installment plan. The risks inherent in this method are (a) the ability of the partners to purchase the shares, (b) business value changes during the installment period may create resentment on one side, (c) capital must be diverted away from business or personal use towards funding purchase, (d) risk of the business failing before payments complete. The benefits are the simplicity of the plan and little associated costs.
- Loan – The remaining business owners apply for a loan to purchase the reallocated shares. The risks inherent in this method include (a) unknown ability to get a loan at an unknown futre date during unknown economic conditions (b) applying for loans can get cumbersome during a time of high emotions and business transtion (c) high costs associated with loans (d) capital diverted away from business operations and toward loan payments. The benefits of getting a loan to fund a buy sell agreement are that the surviving family receives a lump sum for the current value of the business and can be left to grieve
- Life Insurance – Funding a Buy Sell Agreement with life insurance provides the greatest benefits at a resonable cost…however, it must be designed in advance (you can’t get postmortem life insurance). In a simple, two partner Cross Purchase Buy Sell Agreement, each partner owns a life insurance policy on the other partner for the amount of business ownership. The cons to this method include (a) life insurance policies need to be updated to reflect most recent business valuation (b) a partner may not be able to obtain life insurance due to health related issues. The benefits of this method include (a) immediate tax free cash available to purchase business shares (b) business capital is not repurposed for an unexpected purchase, (c) the surviving family receives a lump sum quickly and can be left to grieve.
Buy Sell Agreement Life Insurance Strategies
Your business structure will determine the structure of the buy sell arrangement and life insurance strategies utilitzed. Below are the general Buy Sell arrangements.
A One Way Buy Sell Agreement usually envolves a scenario where the business has one owner or majority owner with key people responsible for the strength of the company and the skills to run the business after the owner’s passing. The Buy Sell Agreement states that if the business owner dies, the key employees will recieve the life insurance death benefit to purchase the business from the deceased’s owners heirs. The life insurance policy in this strategy is also known as a Key Man Policy.
One Way Buy Sell Life Insurance Policy Design
Buy Sell Agreement Parties
Life Insurance Beneficiaries
A Cross Purchase Buy-Sell Arrangement ensures business continuity and maintains marketablility in the event of an owner’s death. This will also guarnatee a buy for shares of the business, provides liquidity for a deceased owner’s family and avoids conflict of interest between surviving owners and the family of the deceased owner.
The agreement provides that on the death of one owner, the surviving owner(s) will buy the deceased’s owners share of the business with cash.. Each business owner applies for and owns a life insurance policy on the other owner(s).
Life Insurance Policy Designs
Life Insurance Proceeds
An Entity Repurchase Agreement envolves multiple owners of the business. The owners enter into an agreement (prepared by an attorney) stating that should any owner die, the business will purchase the shares from that owner’s heirs. The business purchases life insurance policies on each owner, and is the sole beneficiary. The beneficiary proceeds provide the business with income tax free funds to purchase the deceased’s share’s from the surviving heirs.
Life Insurance Policy Design
Life Insurance Proceeds
A Cross Endorsed Buy Sell Arrangement is a business succession strategy in which the business owners purchase life insurance policies on their own lives, and “rent” a portion of the death benefit to the other owners. The rented portion of the deatch benefit serves as a source of funds with with to purchase shares of a deceased owner. The Cross Endorsed Life Insurance can have a dual purpose, both satisfuing the succession planning of the business, while also establishing an Supplemental Executive Retirement Plan through the cash value build up within the policy.
Cross Endorsed Life Insurance Policy Design
Cross Endorsed Life Insurance Proceeds
A Lifecycle Buy-Sell Arrangement is an agreement that can ensure the smooth transition of business ownership in the face of the loss or disability of a business owner. Business owners create a new entity (usually an LLC) to own the life insurance policies on each owners lives. Owners contribute money to the entity to pay the life insurance premiums. In the event of a buyout trigger, policy values or death benefit can be used to fund the buyout.
This strategy segregates the life insurance from the other business assets for creditor protection. A lifecycle buy sell uses cash value life insurance (not term insurance) that can grow in value over time and provide a source of funding for other business owner life stages, such as a downturn, disability, or departure from the business.
Lifecycle Buy Sell Agreement Design
[CASE STUDY] Cross Purchase Buy Sell Agreement
A local Orange County business entity is strucutred as an LLC. There are three owners, a majority owner (Tom) with 60% ownership, and two minority owners (Rob and Julian) each with 20% ownership. Most recent business valuation is $62,000,000.
After a strategy meeting, they discussed succession planning.
Tom, the majority owner has two grown children in their own careers, and a wife.
Rob and Jilian are both married, and each have young children.
As they have not designed any formal succession plans for the business, if one of the owners were to tragically pass, their interest in the business would automatically pass to their spouses. None of their spouses has the technical experience, nor the desire to help run the business, and neither do their children.
The partners agreed that they would all prefer that in the event of one of them passing, the remaining partners would purchase the deceaseds partner’s shares from their family.
Tom’s 60% ownership in the business is valued at $37.2 million.
Rob and Julian’s ownership in the business is valued at $12.4 million each.
They all agreed that the best way to fund a reallocation of shares is through life insurance. This type of planning would require a three-way Cross Purchase Buy Sell Agreement.
Three Way Cross Purchase Buy Sell
In the Three Way Cross Purchase Buy Sell Agreement, each of the business owners owns a life insurance policy on each other. The Three Way Cross Purchase requires 6 life insurance policies.
In this case study, Tom purchased two life insurance policies.
- Policy 1 on Rob for $6.25 million
- Policy 2 on Julian for $6.25 million
Rob purchased two life insurance policies.
- Policy 3 on Tom for $18.6 million
- Policy 4 on Julian for $6.25 million
Julian purchased two life insurance policies also.
- Policy 5 on Tom for $18.6 million
- Policy 6 on Rob for $6.25 million
Term or Permanent Life Insurance for Buy Sell Agreement
The most cost effective method for funding a Buy Sell Agreement is usually with term insurance. The owners could purchase term policies that remain in force until the anticipated retirement of each owner.
If the only function of the life insurance is to fund the Buy Sell Agreement, term policies make the most sense.
However, in our case study, Tom, Rob, and Julian decided that a permanent life insurance policy can provide some additional benefits.
While each owner is still working, the permanent life insurance policies cash value can be borrowed against to help fund business investments, or operations if they experience a downturn.
Furthermore, upon retirement, the insured’s policy will be re-assigned.
Tom will be the first to retire. Upon his retirement, Rob and Julian will each transfer ownership of the policies they own on Tom over to him.
These policies will provide tax advantaged distributions during Tom’s retirement.
Now that Tom is retired, he has no need for the in force policies he has on Julian and Rob.
The Buy Sell Agreement stipulates that Tom will in turn re-assign the policies he has on Julian and Rob over to them, and the cash value can be utilized to purchase a portion of Tom’s retiring stock, or remain in the policies to grow and help fund their own Supplemental Executive Retirement Plan.
Asymetrical Three-Way Cross Purchase Buy Sell Agreement
In this case study, Tom owns 60% of the business. So Rob and Julian have to purchase larger policies on Tom. Additionally, Tom is older than Rob and Julian, so the cost of insurance is higher. Therefore, Rob and Julian have to pay a greater sum for their policies on Tom than Tom has to pay on Rob and Julian.
How was this reconciled?
In the event of Tom’s premature death, Rob and Julian would large tax free death benefit for a relatively small amount of total premiums.
But in the hopeful event that Tom retire’s, Rob and Julian each paid large sums of premiums over the years only to hand the ownership of the policies over to Tom, who gets to reassign beneficiaries and recieve tax advantaged distributions to supplement his retirement.
In their Buy Sell Agreement, in the event of Tom’s retirement and reassignement of policies, Tom would be legally obligated to reduce the purchase price of his shares by the amount of premiums paid into the policies.
So Rob and Julian have effectively been making installments to purchase Tom’s share in the business from the moment they initiated the Buy Sell Agreement with life insurance.
A Closer Look At Tom’s Life Insurance Policies
Below is the illustration for one of Tom’s policies (That is Rob’s the owner on Tom’s life). Tom is 55 years old when this policy went into effect. The Buy Sell Agreement was put in place so that Tom and Julian will buy Tom’s shares in the event of his retirement, or his premature death.
Tom’s share in the business is valued at $$37.2 million. Rob and Julian will purchase equal amounts of Tom’s shares….$18.6 million each.
On day one the contract is in force, Rob and Julian each have access to $18.6 million tax free to purchase Tom’s shares from his family in the event of a premature death.
Tom is planned to retire from the business at age 70.
Rob and Julian have identical policies on Tom’s life, each paying $500,000 in premiums each year. By the time Tom retires at age 70, both Rob and Julian will have contributed $8 million each.
Their Buy Sell Agreement stated that each year they contribute $500,000 to Tom’s policies, Rob and Julian’s ownership percentage in the company increases by that amount. By the time Tom retires, each will have increased their ownership in the company by $8,000,000 (the total amount of premium contributed).
This accumualation strategy works well for Rob and Julian as the assumption is the value of the business will contiune to increase each year by approximately 10%. This allows them to begin accumulating more ownership at lower values.
Once Tom has retired and the policies Rob and Julian own on him are transfered to his ownership, Tom will be able to withdraw approximately $926,059 each year from each policy in tax free distributions.