Ensuring Business Stability with Strategic Buy-Sell Agreements


Who will take over the business? It’s the most critical question in selling a business interest. In a family business, planning takes on even more importance because of the numerous opportunities for conflict. While 90 percent of U.S. businesses are family-owned, that doesn’t always mean that there is an obvious successor, and the choice of a new leader is critical to the company’s survival. Let’s look at some common scenarios.

  • One son or daughter is ready and waiting to take over the reins. This is ideal since it is the easiest situation, but there is a downside. The business owner may be lulled into believing that succession will simply take care of itself. The reality is that without careful planning, the business could still fall apart during the transition, leaving nothing for the next generation and much less for the heirs.
  • Multiple children are vying to lead the company. This forces the business owner to make sensitive and difficult decisions.
  • One family member is keen to take over but is not up to the task. Not all children have the talent, disposition, or background to succeed the business owner. This also puts the business owner in an awkward and difficult position. Even with the right training and education, it’s possible the interested family member may still not have what it takes to lead.
  • No one in the family is interested in taking over the business. This, too, is complicated. Finding an outside buyer is an option, but it is not necessarily easy. While a sale to an outsider may generate the best price, it may not be the best alternative for employees or clients. Therefore, business owners who will not be keeping the company in the family often turn to key employees to take over. A key employee is familiar with the company and the current owner’s vision, and the owner can groom the employee as a replacement.

Owners typically want someone—family or not—with education and experience. Someone mature enough to be knowledgeable but young enough to have plenty of years left to lead the company. Someone eager for the position, passionate about the work, loyal to the company, and dedicated to the owner’s vision.

A Critical Planning Tool

The only way to ensure that the right person takes over a company when the current owner retires or dies is to plan for it. A buy-sell agreement is not only an important planning tool, it’s the first step in ensuring an orderly and successful business transition. This legally binding agreement, drafted by an attorney, can be as simple or as complex as needed and it can be tailored to the needs of each business.

A buy-sell agreement specifies:

  • the circumstances under which the owner will sell the business (retirement, disability, or death)
  • who will purchase the business (family members, co-owners, a key employee, or an outsider)
  • how the business will be valued at the time of the sale (either a fixed amount or a formula for determining the value)

The Benefits of a Buy-Sell

A properly drafted buy-sell agreement:

  • creates a market for the business, encouraging confidence in the ongoing vitality of the business in the eyes of clients, creditors, and employees
  • reduces the likelihood of disagreements over the proper value for the business and can establish the value of the business for estate tax purposes
  • minimizes the possibility that a family business will fall into the hands of outsiders
  • ensures business continuity along with fair treatment for a deceased owner’s heirs

Buy-Sell in Action: Adventure Tours

Abby, Bob, and Carl own Adventure Tours together. Carl dies in an unfortunate bungee-jumping accident. His business interest passes to his estate, and ultimately to his wife, Diana—a first-grade teacher with absolutely no business experience.

Abby and Bob nervously wait to see what Diana will do:

  • If Diana decides that she wants to be involved in the business despite her lack of appropriate knowledge and experience, Abby and Bob will be stuck with her.
  • If Diana decides she needs the money and sells the business interest to a stranger, Abby and Bob will be stuck with a stranger as a business partner.

All Abby and Bob want to do is to purchase the business interest themselves. They want to keep running Adventure Tours, but since they didn’t plan for these circumstances, they don’t have enough cash to purchase Diana’s interest. All Diana wants is cash to replace the income Carl enjoyed from the business. She has no interest in travel or in running a business.

Had Abby, Bob, and Carl put in place a fully funded, buy-sell agreement, none of these unpleasant problems would have arisen. In fact, the transition would have been much easier for all of them:

  • Diana would know who would buy Carl’s business interest and how much the buyer would pay for it. She wouldn’t have to worry about where the money would come from or be burdened with other difficult decisions concerning management or ownership.
  • Abby and Bob would be able to continue running the business without interference. Under the terms of the fully funded buy-sell agreement, Diana would be required to sell Carl’s interest, Abby and Bob would be required to buy his interest at a specified price, and life insurance would provide the cash needed to fund the purchase.
  • Diana wouldn’t be stuck in the position of having to choose between stepping into a business she knows nothing about or struggling to find an outside buyer.
  • Diana would have the money from the sale of Carl’s interest to take care of estate expenses and other income needs after Carl’s death.

Nothing without Funding

Of course, as you can clearly see from this example if a buyer doesn’t have the necessary cash to make the purchase, the agreement is essentially worthless. Some businesses rely on building a sinking fund—an investment reserve fund for this purpose. However, this takes time and is subject to market and economic fluctuations. There’s no guarantee that the business will have the funds it needs, especially if the owner dies prematurely.

Life insurance is the ideal way to ensure the exact amount of cash is available to the buyer at the precise moment it’s needed. As long as premiums are paid on time and there are no significant loans or withdrawals, the death benefit will provide the funds to make the purchase whenever the time comes.

As a funding tool, life insurance enjoys three critical benefits:

  1. It provides funds precisely when they are needed.
  2. It does not require a substantial number of months or years to accumulate the necessary funds—death benefits are available immediately once the policy is in force.
  3. It helps the buyers meet their obligations in a cost-effective manner, even taking into account the time value of money.

How a Fully Funded Agreement Works

Here’s how a fully funded buy-sell agreement works:

  • The buyer purchases a cash-value life insurance policy on the business owner’s life.
  • Cash values accumulate and grow on a tax-advantaged basis.
  • If the business owner dies before reaching retirement, the full death benefit is available to buy the business.
  • When the business owner is ready to retire, the buyer buys out the retiring owner using loans and withdrawals to access policy cash value tax-free.

If the business owner retires before the policy cash value is sufficient to cover the purchase price, the buyer could pay the balance of the buyout in installments using the net income from the business to complete the purchase. In a case like this, the retiring owner may want to insure the life of the buyer to make certain the business owner receives the full purchase price even if the new owner passes away prematurely.

A Versatile Funding Tool

Life insurance is a versatile tool that does more than simply satisfy a contractual requirement in a buy-sell agreement:

  • It provides essential funds for the business if and when the business suffers a financial loss due to the premature death of a key contributor.
  • It prevents unnecessary financial strain for the business and the surviving owners and helps ensure that a deceased owner’s heirs are treated fairly when they sell the business interest.

Let’s look at the four types of buy-sell agreements and examine how life insurance can be used with each of them.

Cross-Purchase Agreement

This is a common type of buy-sell agreement that is used in businesses with multiple owners. In essence, a cross-purchase agreement provides that upon the death of one owner, the surviving owners will buy and the deceased owner’s heirs will sell the business interest at an agreed-upon price. The goal of this agreement is to protect surviving owners from interference by outsiders while at the same time ensuring fair treatment for the deceased owner’s heirs.

To fund this agreement, each owner buys a life insurance policy on every other owner. When one owner dies, each surviving owner uses the life insurance proceeds to purchase the deceased owner’s interest. The graphic shows how this works for a business with two owners.

Cross Purchase Agreement Image

Let’s return to our earlier Adventure Tours example to see what happens in a business with three owners. Abby, Bob, and Carl are equal partners, and the total value of the business is $6 million. Each owner has an interest of $2 million. Under a cross-purchase agreement, each owner agrees that at the death of one partner, the other two will purchase the interest of the deceased owner from the deceased owner’s estate.

To fund such a potential purchase, each owner would purchase two life insurance policies—one on each business partner. For example, Abby and Bob each purchase a policy with a $1 million face amount on Carl. The total insurance coverage on Carl is then $2 million—just the right amount to purchase his interest.

When Carl passes away, Abby and Bob would use the life insurance proceeds to buy Carl’s business interest from his estate. This leaves Carl’s wife, Diana, with $2 million in cash from the sale of Carl’s business interest. It also leaves Abby and Bob in charge of Adventure Tours, each now with a 50 percent interest. In a cross-purchase agreement, ownership remains the same in relation to the other owners. In this case, since the owners were all originally equal, they remain equal after Carl dies.

And what happens to the policies that Carl owned on Abby and Bob? The agreement should also provide for the surviving owners to purchase the deceased owner’s policies from the estate. Of course, other arrangements are possible but could cause transfer-for-value issues if a policy is sold to anyone other than the insured or the business itself.

Entity Purchase Agreement

With this type of agreement, the business itself is a party to the sale. An entity purchase agreement stipulates that the business will buy a deceased owner’s shares and the heirs will sell the shares at an agreed-upon price. To fund the agreement, the business purchases life insurance for each of the owners. The business owns the policies and is the beneficiary of the policies. The face amount of each policy approximates the purchase price for the insured owner’s interest.

In some situations, an entity purchase agreement is preferable to a cross-purchase agreement:

  • When there are a number of owners, a large number of life insurance policies would be required under a cross-purchase agreement. An entity purchase agreement avoids this problem since an entity buy-out calls for only one policy per owner.
  • When there is a wide disparity in the ages of the owners, younger owners are forced to pay higher premiums for policies on the lives of older owners under a cross-purchase agreement.
  • When the business wants the cash values of the policies to be available as reserve funds, the business itself must own the policies. Of course, using the cash value reduces the death benefit, which could possibly defeat the purpose of the agreement.

In our Adventure Tours example, let’s say that Abby was 35, Bob was 60, and Carl was 45. If they use a cross-purchase agreement, Abby and Carl would have to pay higher premiums for an insurance policy on Bob than Bob would have to spend on premiums for policies insuring them. An entity purchase agreement would remove that disparity.

The graphic below illustrates how an entity purchase agreement works.

Entity Purchase Agreement Image

One-Way Buy-Sell Agreement

This agreement allows a business owner to identify a potential buyer (perhaps a key employee) who agrees to purchase the owner’s interest. A one-way buy-sell agreement is most common in businesses with a sole owner and no obvious heir.

Let’s say that both Carl and Bob died, leaving Abby as the sole owner of Adventure Tours. She has no children or other family members who are interested in the business, but Erin, one of Adventure Tours’ long-time employees, seems to have the right mix of drive and experience. Abby could create a one-way buy-sell agreement with Erin to ensure a smooth ownership transition in the event of her unexpected death.

Wait-and-See Buy-Sell Agreement

This is a hybrid agreement that combines elements of the cross-purchase and entity buy-sell agreements usable by all businesses with multiple owners. In a wait-and-see buy-sell agreement, the business entity has the first chance to purchase the deceased owner’s interest.

If the business passes on all or part of the interest, the surviving owners then have a chance to purchase the interest for a certain period of time. If they pass on any part of the interest, the business entity is then required to purchase whatever remains. In some situations, this flexibility is very important.

In the case of Adventure Tours, when Carl passed away, the business itself would have the first option of purchasing Carl’s shares from his estate. The business could buy all, some, or none of the shares. Let’s say the business passed. Then Abby and Bob would have the option to purchase Carl’s shares.

Abby purchases 25 percent of Carl’s shares and Bob purchases 50 percent. The business is then required to purchase the remaining 25 percent of Carl’s shares, ensuring that Carl’s family gets cash for his full business interest, while also ensuring that Abby and Bob retain full control of the business, even though they chose not to personally purchase all of Carl’s shares.

With a wait-and-see agreement, the business buys life insurance for the owners, and the owners also may have policies on each other. However, the business has the greatest exposure since it is required to purchase the interest if the other owners choose not to.

Business and Personal Planning Are Inseparable

We’ve talked about the fact that business succession planning and personal estate planning are intertwined, but almost nowhere is that idea more visible than in a buy-sell agreement. Business insurance helps keep the business viable, even following the unexpected loss of the owner or a key employee. If the business is not viable, the family will not benefit from a deceased owner’s share—they will lose not only the owner’s salary but potentially the biggest “investment” asset in the estate. This double blow can be devastating to a family, just as they’re trying to deal with the grief of losing a loved one.

A properly drafted buy-sell agreement:

  • protects the business and ensures its continuation
  • assures the business owner’s heirs of fair treatment and proper compensation for what is likely the biggest asset in the decedent’s estate
  • provides the business owner’s heirs with sufficient liquidity to cover estate expenses and taxes

Of course, the IRS is also interested in getting its fair share. The value of the deceased owner’s business interest is included in the estate and affects the amount of estate tax due. Consequently, business valuation must not only be fair to the surviving owners (or other buyers) and the deceased owner’s heirs, but it must also be acceptable to the IRS. In essence, this means that the price must be fair and adequate at the time the buy-sell agreement is executed.

If the IRS finds the valuation unacceptable, it could result in extensive and costly litigation, which in turn could delay the settlement of the estate—perhaps for years. Family members have to be especially careful to set a proper valuation—in other words, a value that is comparable to the price an outsider would pay. The IRS does not look kindly on buy-sell agreements used as a means to pass down a business interest for less than the full value, since the IRS views this as merely a scheme to avoid paying estate taxes.

Valuing the Company

Valuation is the heart of a buy-sell agreement, but despite its vital importance, there is no clear and consistent method for establishing a business valuation. The agreement can stipulate:

  • a fixed price
  • a formula for setting a price
  • an appraisal
  • a combination of these methods

A fixed price may become unrealistic as time passes. The formula approach is a good way to ensure a current price, assuming the formula is spelled out clearly in the agreement. A buy-sell can instead require one, two, or even three separate independent appraisals, and can provide specific guidelines for those appraisals if desired. A combination of formula and appraisal is also common, with the appraisal used to modify the amount determined by formula if need be.

Factors that Impact Valuation

Determining a fair value means taking these business and economic factors into consideration:

  • the history and nature of the business (including stability, capital structure, growth, and diversity)
  • trends within the national economy and the specific industry
  • the financial condition of the business (balance sheets and book value are both important)
  • earning capacity of the business (this may be the most significant factor in valuation)
  • dividend-paying capacity
  • goodwill (intangible items such as reputation, ownership of brand names, skill and experience of employees, prestige, and even customer loyalty)
  • previous sales of stock (were the sales forced, or were they isolated cases?)
  • fair market value of publicly traded stock of comparable businesses

The specific situation will determine which of these factors are more heavily weighted. For example, in a business selling goods and services, earning capacity might be the most important factor, whereas in a corporation holding real estate, the financial condition might be more important—in particular, the net asset value.

As you can see, business valuation is complex. While an understanding of the process will help you determine how life insurance can meet specific funding needs, the valuation itself should be left to specialists.

A Note about Employer-Owned Life Insurance

Death proceeds flowing into a corporation may actually increase the value of corporate stock. Business owners should consider this factor when drawing up a buy-sell agreement and a method for valuation.

There are also notice and consent requirements for employer-owned life insurance, and it is vital for business owners to follow the rules if they want the life insurance proceeds to be free of federal income tax.

These items do not minimize the importance of life insurance as a funding vehicle, but they should be considered during the planning process so there are no surprises when the agreement is executed.

A Fictional Example: Family Business Planning Done Right

Of course, we’ve seen that for every different type of business situation, there is a compelling reason to plan and appropriate planning tools to accomplish a successful transition. Let’s look at one example of a family that took the necessary steps to ensure that the original business owner’s interest would transfer seamlessly to his son.

Renford & Smith, LLC

Sam Renford and Clarence Smith formed Renford & Smith, LLC—a small but successful real estate business that represents the majority of home sellers in their wealthy seaside market. The company is valued at $10 million.

Clarence, a 40 percent owner and once a star salesman, has since retired to Florida with medical issues. Sam, a 60 percent owner, brought in his wife to help fill Clarence’s role. Their grown son, Andrew, also joined the company. Andrew’s excellent business sense and sales rapport have played a key role in keeping the firm growing and profitable. In fact, Andrew has grown increasingly important to the company while Sam has become more and more interested in retirement.

Father and son discuss an equitable business succession plan. With the help of their financial team, they select a one-way buy-sell agreement in which Sam agrees to sell his interest to Andrew at death or retirement for its fair market value of $6 million. They fund this agreement by having Andrew purchase a life insurance policy for his father with a $6 million face value.

The business will pay the premiums as deductible compensation to Andrew. As Andrew’s management role (and income) increases, he will also begin an installment buyout of Clarence’s shares.

In addition, the company purchases a key employee policy on Andrew in order to protect the business in the event of Andrew’s premature death.

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