You have worked hard to build your business, but there are events outside your control, like death or disability, that can negatively impact it.
Thankfully, you can plan for these contingencies using a buy-sell agreement.
A buy-sell agreement is a practical deal for protecting the people who rely on your business, its owners and their families, employees, customers, and other stakeholders.
Generally, a buy-sell agreement involves purchasing life insurance, with each business partner getting a life insurance policy equal to their stake in the company. When a partner leaves, the remaining partners or the business itself can use the insurance proceeds to buy out the partner’s shares and ensure business continuity.
You'll learn:
What is a buy-sell agreement?
"If you own a business with multiple owners, having a buy-sell agreement in place is crucial. It's a contract that you enter when times are good—to plan for when times are not so good." - Greg Rozdeba, CEO of Dundas Life and Certified Life Insurance Advisor
A buy-sell agreement is a legal contract that outlines the process for the entry or exit of a company shareholder. It documents how an owner’s interest in the company may be swapped, purchased, and sold in the event of certain predefined events. These events can include death or termination of employment with the company due to a disability or other reason.
A buy-sell agreement usually requires that if one business owner dies or wishes to give up their shares, their share can only be sold to the remaining partners. This ensures that the surviving co-owners retain full control over the business.
In other words, buy-sell agreements prevent beneficiaries of the deceased owner’s estate and others from buying into the business and having a say in how it's run.
Business Example: Maverick Cleaners Co
For instance, let's say Maverick Cleaners Co. has four business owners — Robert, Susan, Michael, and Debby — each with a 25% stake in the business.
If Robert dies and there is no buy-sell agreement, his share would be passed on to his estate. That would allow his heirs to have an ownership interest in Maverick Cleaners Co — which might not go well with the other co-owners. A buy-sell agreement could prevent this by only allowing Susan, Michael, and Debby to buy Robert’s stock in the business upon his death.
A buy-sell agreement can also come in handy in other situations. Suppose Robert is diagnosed with a life-altering condition and wants to relinquish his stake in the business. With a buy-sell agreement in place, Robert can easily monetize his stake in the business. The agreement not only defines the valuation method for the goods but also the manner in which they can be sold to other co-owners.
Buy-sell agreements minimize the impact that death or other unfavorable circumstances may have on your business. It also helps avoid complicated and lengthy legal disputes by clearly spelling out the scenarios in which remaining partners can buy a co-owner’s stock in the business, how the business interests will be valued, and how the buyout agreement will be funded.
A well-designed buy-sell agreement offers the following benefits:
- Known buyers for your stock in the company: You know in advance who will buy your shares in the business upon your death or termination of employment.
- The purchase price: You know beforehand how the business will be priced at fair market value, allowing you and your family to plan for the future with confidence.
- Business stability: Employees, suppliers, and customers know in advance who will lead the business following your planned or unplanned departure from the company. This knowledge will help them feel more secure and increase their likelihood of remaining with the company after your departure.
- Minimize potential disputes among shareholders: A buy-sell agreement comes into effect when all the concerned parties agree to its terms and sign the document.
- Better access to credit: Buy-sell agreements ensure business continuity after a potentially disrupting event. With an agreement in place, lenders will feel more comfortable about the company’s future and be more open to extending credit.
- Greater financial security at retirement: Since owners know how much money they will receive in retirement and from whom, they can plan for their life post-retirement with greater confidence.
What is corporate-owned life insurance?
Similar to how an individual can take out life insurance on someone, a corporation can also take out a policy on an important person, such as a CEO or executive. This is called business or corporate-owned life insurance (aka COLI). When the corporation is named as the beneficiary, it will receive a benefit if the key person dies and can use this money to cover any loss of production and assist in hiring a replacement.
There are many benefits of corporate-owned life insurance, such as:
- Securing a loan: COLI can be used as collateral
- Protecting your business: Ensuring key employees means business will run smoothly in their passing
- Succession or estate planning: the payout from a life insurance policy can be used as an inheritance
- Tax-free growth: some policies include a savings component called cash value, which the business can use
- Funding a buy-sell agreement: a redemption agreement involves a business taking out a policy on the owner(s)
How do buy-sell agreements work?
Buy-sell agreements define how a business will proceed if an owner or partner dies or leaves the company.
Typically, buy-sell agreements involve the following steps:
- Determine the events that trigger a buyout. For example, death or disability of an owner.
- Determine all the parties that have rights and purchase obligations.
- Set the purchase price or define the formula or process for valuing the business.
- Establish how the buyout will be funded. For example, will the agreement leverage any other life insurance policies?
- Define what will happen if one or more involved parties do not use their purchase rights.
- Declare whether the business will be restructured after the buyout. If so, how will it be restructured?
The agreement is essentially a barter between the owners in the event that one of them passes away. This trade will assist the company to run smoothly even after tragic events.
Types of buy-sell agreements
Each company is different. There is no such thing as a one-size-fits-all buy-sell agreement. To assure business continuity in the case of a stakeholder's death, incapacity, or retirement, thoroughly assess your company's particular circumstances. To determine which sort of buy-sell agreement will best suit your requirements, consult with a trusted buy-sell agreement broker at Dundas Life.
The four most common types of buy-sell agreements include:
Cross-Purchase Agreement
A cross-purchase agreement allows company shareholders to buy the shares of a co-owner when a triggering event occurs. As part of the agreement, each business owner purchases a life insurance policy on the other business partner(s).
- For example, let's imagine Mike and Arnold co-own a bakery business called SmoothDough. To ensure business continuity and a smooth swap of ownership from the departing partner, they enter any cross-purchase agreements. This means that each owner buys life insurance on the life of the other and pays the premiums out of their own pocket. The beneficiary of Mike’s policy will be Arnold and vice-versa.
The face value of any life insurance policy depends on the value of a co-owner’s stocks, as the death benefit must be enough to fund the purchase of the late owner's shares.
- For instance, if Mike’s shares are worth $10 million, Arnold will purchase a $10 million policy on his life. Upon Mike’s death, Arnold will use the life insurance payout to pay for his share of the company. This will enable the company to cover merchandise and supply, ensuring that no buyer is disappointed.
Redemption Agreement
In a redemption agreement, the company itself purchases the shares when a triggering event occurs.
A company will usually use life or disability insurance to help fund a repurchase if a shareholder passes away or becomes disabled. The company pays the premiums, and the company is also the beneficiary. Typically, only one policy is purchased per shareholder.
- Continuing with the above example, instead of Mike and Arnold buying a policy on each other, their company, Smooth Dough, purchases a policy on both of them and pays the premiums. If an owner dies, retires, or becomes disabled, Smooth Dough will use the proceeds of their life insurance policy to repurchase their stocks for a preset price.
Hybrid Agreement
A hybrid agreement, sometimes referred to as a wait-and-see agreement, can create certain obligations and rights for both the shareholders and the company. For instance, a hybrid agreement can require cross-purchase agreement obligations under certain circumstances, like the death of a stakeholder, and redemption obligations for specific events, like the retirement of most business partners.
- For example, under a hybrid agreement, Mike and Arnold take out life insurance policies on each other. If one of them dies, the other will buy the deceased partner’s stocks at a pre-determined price. However, since not all disrupting events are insurable, Mike and Arnold decide to go with the redemption option for other situations. So, when either of them retires, SmoothDough will repurchase their stake in the company at a fixed price.
Entity Purchase Agreement
In an entity purchase agreement, the business purchases the shares of a stockholder when they leave the company. The remaining business owners then rearrange their stake in the business so that they are equal partners.
- For example, let's say in the scenario above, SmoothDough was shared between three owners originally: Mike, Arnold, and Pete, all with equal shares in the company. If Pete dies, his share of the business will end up getting split between the other two owners. This way, Mike and Arnold will end up having equal 50/50 shares in SmoothDough, instead of having the company be passed on to Pete's heirs.
Who needs a buy-sell agreement?
Any business with more than one owner benefits from having a buy-sell agreement. However, a limited corporation and a sole proprietor may also benefit from setting up an effective buy-sell agreement.
The following types of businesses are likely to need a buy-sell agreement:
- doctor’s offices
- dental offices
- law firms
- auto mechanics
- physical therapists
- family-owned businesses
- restaurateurs
- landscapers
- local retailers
What should be included in a buy-sell agreement?
A buy-sell agreement should clearly outline three things: the triggering events, the process that will be followed for valuing the business, and how the sale of ownership will be funded.
Triggering Events
Events that usually trigger a buy-sell agreement include, but are not limited to, the following:
- the death of a shareholder
- a critical illness
- a long-term disability
- termination or resignation of the shareholder as an employee
- retirement
- divorce
- bankruptcy declaration
A buy-sell agreement must clearly define what constitutes a trigger event. While certain trigger events, such as death, may not require explanation, others must involve precise and specific descriptions. For example, if disability is mentioned in the contract, it must specify how total disability will be determined. Similarly, the agreement should clearly state which medical conditions will be designated critical illnesses.
If the buy-sell agreement is backed by life insurance, the various triggering events should be defined in the same way as the insurance contract.
Business Valuation
A buy-sell agreement should define how the business will be valued. Some small business owners choose a pre-determined amount (e.g., $2 or $5 million), while others prefer to use a specific formula (e.g., six times pre-tax earnings) or hire a business valuation expert. If you and your business partners agree to a pre-determined amount, do not forget to review this figure annually since a company’s value can change over time.
Funding strategy
A buy-sell agreement must outline how any sale of ownership will be funded. The company or the business owners could use the insurance proceeds to buy the business interest. For example, the company or owners may use the payout from:
- Life insurance
- Critical illness insurance
- Disability insurance
In any of these cases, either the co-owners or the business itself would be listed as the insurance beneficiary. When one owner passes away, the benefit then provides funds with which the co-owners or the corporation can buy back the shares of the late owner.
However, insurance policies are not the only way to fund a buy-sell agreement. Business owners may also opt to use cash or take out a loan for funding.
Pros | Cons |
Can provide a stream of income that lasts for the rest of the annuitant's life. | Can be expensive, especially if the annuitant wants to receive a higher income. |
Can be used to create a "floor" of income, which can be helpful in retirement planning. | The payments from an ordinary annuity are typically fixed, which means they may not keep up with inflation. |
The payments from an ordinary annuity are typically fixed, so the annuitant knows how much income to expect each month. | If the annuitant passes before receiving all of the payments from the ordinary annuity, the remaining payments are lost. |
Common buy-sell agreement mistakes
When implemented correctly, a buy-sell agreement paves the way for a smooth trade of ownership in the event of an owner leaving the company. If not implemented correctly, it could lead to major legal issues.
Here are some of the common mistakes to avoid when creating a buy-sell agreement:
Using a generic buy-sell agreement template
A generic buy-sell agreement does not work for all businesses. Unless the agreement is tailored to your business and all of its owners, it is likely to fail when needed the most. Make sure the terms of your buy-sell agreement take into account all the unique aspects of your business.
Vague or improper valuation process
Choose the valuation method that will work best for your business. Stating a fixed price in the buy-sell agreement for transferring sale of ownership might not be the best strategy, unless the involved parties agree to review it from time to time to reflect the fair market value. If the set price is too low, the selling owner or their heirs will suffer. If it is too high, the surviving business owners or the corporation will suffer.
For these reasons, getting the business appraised by an independent party at the time of ownership transfer or using a fixed formula may be a better option.
Overlooking trigger events
It is important that your buy-sell agreement cover all possible trigger events, including death, critical illness/disability, termination/retirement, divorce, and bankruptcy, among others.
Failing to fund the buy-out price
Even if your buy-sell agreement covers all possible trigger events and appropriately determines the buy-out price, it could fail if it does not make proper arrangements for funding it. Therefore, make sure the agreement clearly outlines how cash will be procured when a partner leaves the business.
Conclusion
When a partner passes away or leaves the company, buy sell agreements enable a straightforward transfer of ownership. Typically, life insurance is used as a funding mechanism in these arrangements. Speak with a Dundas Life specialist if you wish to set up such an agreement and fund it with a life insurance policy. We can assist you in getting the appropriate level of insurance coverage to protect your company from serious financial and legal problems.
Frequently Asked Questions (FAQs)
Generally, buy-sell agreements are legally binding. To ensure that agreements are drafted properly to include all of the necessary components, be sure to speak with a legal professional.
The company itself or the surviving business partners are the beneficiaries of the life insurance policy used for funding a buy-sell agreement. Generally, when a corporation has multiple business partners, it is better to name the business as the owner and the beneficiary of the life insurance policy. When the insured passes away, the beneficiary (either the corporation or the remaining partners) uses the payout to buy the deceased partner’s shares.
Steven has a deep background in life insurance. At Dundas Life, he's helped 1000s of clients find the right insurance coverage while also training dozens of insurance advisors during his career. Previously at Finaeo, Steven oversaw compliance and coaching for over 350 independent insurance brokers. Steven is also rated the #1 Insurance Agent in Toronto on Rate-My-Agent.
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