Why Buy-Sell Agreements Are Critical for Businesses

When forming a company or new venture, at the outset there is typically a great deal of planning and enthusiasm among the business partners for the opportunities that lie ahead. Everyone is on the same page…yet as time goes on, things can and do change – and not always for the better. In establishing a business partnership, part of the planning process should include a formal, well-written agreement that defines what will happen in the event of a partner’s death, disability or retirement. A Buy-Sell Agreement will define the ownership succession plans, avoiding confusing and costly disputes that can potentially arise between owners and situations that can disrupt the business and hurt its value. It protects all owners and/or family members and provides certainty in the event an unexpected crisis necessitates a change in leadership.

Each Buy-Sell Agreement should be tailored to meet the unique circumstances of the particular situation. It can be part of an operating agreement or a stand-alone document. Following are some common elements that Buy-Sell Agreements should include:

  • Names of the individuals who could purchase a departing partner’s or shareholder’s share of the business.
  • The types of events that will trigger a buyout. These events typically include: death, disability, retirement, or an owner leaving the company.
  • A method to determine the value of the stock company.
  • A specific outline of how the purchase price will be paid. If Life insurance will be used to fund the agreement, a definite provision regarding the arrangement should be included.
  • A provision to allow for the alteration, amendment or termination of the agreement.

One of the most important considerations in a Buy-Sell Agreement is the purchase price. One method is to establish a specific price, but this can be dangerous as it may not represent the fundamental value of the firm with business and market conditions constantly changing, and it must be updated annually. Using a formula (e.g., a multiple of revenue) may be safer; however, it may also eventually become outdated. The best approach to determine the purchase price is to require a professional appraisal at the appropriate time. This allows an unbiased professional to take all current circumstances into consideration. A current appraisal from an outside party can also help limit disagreement on the value. Yet it’s still important to keep in mind that the Buy-Sell Agreement should remain fluid, and revisited from time to time to ensure that the business valuation is current.

Life Insurance as Part of the Buy-Sell Agreement

Typically, Buy-Sell Agreements are drafted with funding provisions, such as a Life insurance policy, to pay for a buyout. There are different types of plans available when drawing up a Buy-Sell Agreement. One such plan is called a Stock Redemption Plan (Entity Purchase). Each owner under this plan enters into an agreement with the business. The owner agrees to sell his or her individual interests in the business back to the organization rather than pass that ownership onto his or her family members or heirs. The business will buy Life insurance on the owner and pay the premiums. The other owners of the business will receive the proceeds from the sale.

With a Cross-Purchase Plan, each business owner buys Life insurance on the other owners and owns his or her respective policy. If one of the owners were to die, the surviving owners would be the beneficiaries and use the funds to buy out the interests of the owner who passed away. This process is very similar to a Life policy one would purchase on a spouse or loved one. If one of the owners passes away, the surviving owners would receive the payout to be used to purchase the rest of the business and help recover from the loss of the business partner.

The Hybrid Plan is a combination of the above agreements. The entity/business can still take out policies on each co-owner, but the individuals can also purchase Life insurance for the other owners.

Disability Insurance as Part of the Buy-Sell Agreement

Disability Buy-Out (DBO) insurance should also be a part of the Buy-Sell Agreement. If a disabled owner is unable to return to work, DBO insurance enables the business (or the buyer under a Buy-Sell Agreement) to purchase the disabled person’s interest at a pre-determined monthly, annual or lump sum payment level.  Similar to Life insurance, DBO coverage under a Buy-Sell Agreement can be arranged under an Entity, Cross-Purchase, or Hybrid plan.

The professionals at Owens Group assist companies with their Buy-Sell Agreements including providing Life and Disability insurance and determining which type of arrangement is best for a business’ needs. For more information on how we can assist you with your Buy-Sell Agreement, please call Bob Owens or Denise Kligman at 800-26-COVER.