Picture this: you and your friend start a web hosting company in a 12 by 24-foot garage eight years ago. It is now a booming business with offices in six different cities.
You've worked hard to get where you are now, and you'd like nothing more than for your partnership to continue. Yet, things may not go as planned.
What happens if your company partner decides to leave or retire early? How will your company fare if one of you dies unexpectedly?
A buy-sell agreement lays down a clear plan for tackling such life events. Without it, your business may face major financial and legal difficulties down the road, not to mention issues with taxes.
What are buy-sell agreements?
When a shareholder passes away, their part in the company normally falls to their heirs. Neither you nor your business partner - Joe - desire that. While you and your partner are well-versed in web hosting, your heirs are as enthusiastic about it as you are about tree sculpting. A buy-sell agreement ensures that the surviving partner gains complete control of the business.
Life insurance is typically used to fund buy-sell agreements. For example, you and Joe will purchase insurance on each other, and when one of you passes away, their heirs will immediately receive the buyout amount. The surviving owner would then own the entire company.
The death of a business partner, however, is not the only scenario in which a buy-sell agreement can come in handy. It can include other triggering events, like a critical illness, long-term disability, divorce, termination or resignation of a shareholder as an employee, retirement, or bankruptcy.
A buy-sell agreement basically states that if a shareholder dies or sells their position in the firm, their share can only be acquired by the surviving shareholders or the corporation. As a result, surviving owners avoid costly court disputes with the deceased owner's heirs, and persons who do not know or care about the firm are prevented from attaining ownership.
There are four main types of buy-sell agreements:
1. Cross-Purchase Agreement
It enables business partners to purchase a co-owner's shares when a pre-determined event happens. The majority of cross-purchase agreements are supported with life insurance, with each owner purchasing a policy on the lives of the other partners.
For example, you and Joe may take out a policy on each other to ensure a seamless transition of firm ownership. The size of the policy taken out in the insured's name is determined by the value of the insured's portion of the business.
If Joe's shares are worth $20 million, you would need to get a policy of $20 million. You may use the insurance proceeds to buy out his share if he passed away.
2. Redemption Agreement
With a redemption agreement, the company — not the surviving business owners — buy the share of a co-owner when a triggering event occurs. Generally, life insurance or disability insurance is used for funding this type of agreement.
For example, instead of you and Joe taking out a policy each, your company — Learn Rank — buys a policy on each of you. If you or Joe become disabled or pass away, Learn Rank would use the insurance proceeds to buy the deceased’s stocks at a fixed price.
3. Hybrid Agreement
Certain life events — like death, disability or critical illness — are insurable, but some others are not. For instance, a life insurance policy would not pay out if Joe leaves the company. A hybrid agreement makes it possible to cover both insurable and non-insurable events.
A hybrid agreement combines cross-purchase and redemption arrangements. It basically states that a cross-purchase agreement event will take effect under certain conditions (such as the death of a co-owner), whereas a redemption agreement will be activated by other covered occurrences.
For example, you and Joe set up a hybrid agreement, which allows the surviving owner to purchase the deceased’s stake. If one of you retires or moves on, the corporation will purchase the former owner's stake.
4. Entity Purchase Agreement
This arrangement is commonly used by companies with three or more owners. The business in question purchases a policy on each co-owner in an amount equal to the fair market value of their share.
Whenever a shareholder dies or becomes incapacitated, the cash benefit is used to purchase the shares from the owner or their estate. The remaining owners then restructure their position so that they have 100% of the outstanding shareholders or ownership and are equal partners in the business.
How do buy/sell agreements work?
A buy-sell agreement specifies how a business will proceed if a co-owner passes away, retires, or decides to quit the company. It is most typically used by closed corporations, partnerships, and sole proprietorships to ensure a smooth transfer of ownership when a covered event happens.
A buy-sell agreement clearly defines:
- the events (disability, death, retirement, etc.) that will trigger a buyout
- the parties (co-owners and/or the company) that have rights and purchase obligations
- the price at which the co-owner’s share will be purchased or the formula that will be used for determining the value at the time of a covered event
- how the buyout will be funded (e.g. would life insurance fund the agreement?).
Keep in mind that if a buy-sell agreement calls for the remaining shares to be sold to the surviving owners, then the deceased owner’s heirs or estate is legally obliged to do so.
Why is life insurance a preferred way to fund a buy/sell agreement?
It is a common practice to use life insurance for a buy-sell agreement, and it is easy to understand why. On the one hand, a life insurance policy ensures that the deceased owner’s family will not have to wait to receive the payout after his death. Yet, it ensures that surviving owners will not have to borrow money to purchase the former owner's portion.
With a buy-sell agreement, the surviving owners can ensure business continuity without costly interruptions, protect its credit position, guarantee the continuity of the management, and maintain control over their business.
Buy/sell agreement funded by life insurance: potential pitfalls
Whole life insurance may look like a superior option for funding a buy-sell arrangement on the surface. You won't have to worry about the insured outliving the policy because it doesn't have an expiry date.
That said, term life insurance, which can be 10-15 times cheaper than permanent life, is not a bad option either, as most plans can be renewed up to age 75 (if not longer). But make sure you buy a term life policy with the guaranteed renewability clause. This clause safeguards your right to renew.
Simply put, if you wish to renew your policy, the insurer cannot refuse you. The renewal premium is always higher than the preceding rate, although this is not due to a change in the insured's health.
If you want to use life insurance for a buy-sell agreement, there are two pitfalls to avoid:
1. Keep in mind the plan’s expiry date
This problem is limited to term life insurance only. While term life insurance saves money, there is always a possibility that the insured will outlive the plan. The problem can be remedied by renewing the policy before the expiry of its term.
Since renewal premiums can be quite high, you may be better off purchasing a plan with a relatively long term (like a 20- or 30-year term plan).
2. Not taking business growth into account
As your company expands, so will the value of your and your co-owners' shares. As a result, it is likely that the policy purchased a decade ago is insufficient to purchase a deceased owner's share today.
There are two ways to combat this problem:
- Buy permanent life insurance with an increasing death benefit. The face value of your policy will increase in proportion to the increased value of your share in the business.
- Buy a permanent or term life policy that allows you to add riders, giving you the option to buy additional coverage without submitting proof of good health.
Alternative to funding a buy/sell agreement (other than life insurance)
If you do not want to use life insurance for funding a buyout, other options worth exploring are:
- Set aside a percentage of your annual profit or revenue to fund a buyout down the road. How much you should set aside every year for this requirement is not easy. Also, a savings fund will cut into the company’s annual profit or revenue.
- Buy out the share of a former owner in installments. The downside is that the deceased owner’s heirs will retain a partial interest in the business until the buyout is complete.
- Take out a business loan to purchase the shares of a deceased owner. Like the previous two strategies, this arrangement is not foolproof. Your company may not qualify for a loan when it needs it or may have to pay an unreasonably high rate.
Buy sell agreement funded by life insurance: Things to look for
Some additional points to keep in mind include:
- Speak to your accountant or financial advisor to determine which of the four types of buy-sell agreements would be right for your business.
- Make sure you pick the right valuation method. The common practice is to use a specific formula (like five times pre-tax earnings), but you can also go with a fixed amount, provided it is reviewed annually.
- Ensure the agreement includes all important events that could lead to a restructuring of your business, including death, critical illness, retirement and termination, divorce, and bankruptcy.
- Work with an insurance advisor like Dundas Life to find the best (and the cheapest) life insurance policy to fund your buy-sell agreement.
Is a Buy Sell Agreement right for me?
A buy-sell agreement is a legal contract that allows surviving business owners to purchase the shares of a deceased, ill, disabled, retired, or resigned former owner.
In most cases, life insurance is used to fund a buy-sell deal. It eliminates the need for a firm to fund the buy-out and assures that the dead owner's family receives the funds as soon as possible.
Permanent life insurance is typically used to support a buy-sell arrangement, but term life insurance can also be employed. Dundas Life works with some of Canada's top insurers and can help you discover the best insurance at the greatest price.