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 and the need to utilize personal funds or business assets to fulfill the terms of buy-sell agreements.

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. The agreement ensures that the remaining partners completely control the business continuity.

Life insurance is typically used to fund buy-sell agreements. For example, you and Joe will cross-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.

A buy-sell agreement states that if a shareholder dies or sells their position in the firm, the surviving shareholders or the corporation can only acquire their share. 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.

Creating buy sell agreements

Creating a buy-sell agreement is a crucial step in ensuring the continuity of your business. It is a legally binding contract that outlines what will happen to a partner’s share of the business continuity if they die, become disabled, or leave the company. To create this buy-sell agreement, you must consider several factors, including the value of the business, the purchase price, and the payment terms.

First, you need to determine the value of your business. This can be done through a formal business valuation to accurately assess the company’s worth. Once you clearly understand the business’s value, you can set a fair price for the shares.

Next, you need to outline the payment terms. This includes deciding whether the buyout will be paid in a lump sum or installments. It’s also important to specify how the buyout will be funded. Many businesses use life insurance policies to fund a buy-sell agreement, as the life insurance death benefit tax-free can provide the necessary funds to buy out the deceased partner’s share.

Finally, ensure that the buy-sell agreement is a legally binding contract. This means having it reviewed and approved by legal professionals to ensure it meets all legal requirements and protects the interests of all parties involved.

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There are four main types of buy sell agreements  

1. Cross-Purchase Agreement

This type of buy-sell agreement enables business partners to purchase a co-owner’s shares when a predetermined event occurs, often referred to as a partner purchase. Most cross-purchase buy-sell agreements are supported by lifeform ownership transition purchasing, a life insurance policy that governs the lives of the other partners.

For example, you and Joe may take out a policy on each other to ensure a seamless firm ownership transition. 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 pass proceeds to buy out his share if he passes away.

2. Redemption Agreement

With a redemption agreement, the company — not the surviving business owners — buys the share of a co-owner when a triggering event occurs. Generally, life insurance or disability insurance is used to fund a buy-sell 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 will use the insurance proceeds to buy the deceased’s stocks at a fixed price. 

3. Hybrid Agreement

Certain life events —if Joe had a disability or critical illness — are insurable, but some others are not. For instance, a life insurance policy would not pay out if Joe left 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. Other covered occurrences will activate a redemption agreement effect under certain conditions (such as the death of a co-owner), whereas other covered occurrences will activate wait-and-see businesses. A wait-and-see agreement allows for a hybrid agreement that provides flexibility in deciding the purchase structure based on the business’s needs when necessary.

For example, you and Joe set up a hybrid agreement allowing 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

Companies with three or more owners commonly use this arrangement. 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 share will be purchased or the formula that will be used for determining the value at the time of a covered event 
• How will the buyout be funded (e.g., would life insurance fund the agreement?)?

Remember that if the agreement calls for the remaining shares to be sold to the surviving owners, the deceased owner’s heirs or estate is legally obliged. 

Why are life insurance owners to fund buy/sell agreements?

An owner’s insurance policy ensures that the deceased owner’s family will not have to wait to receive the payout after his death. Yet, it means 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 their credit position, guarantee the continuity of the management, and maintain control over their business.

Buy sell agreement funded by life insurance: potential pitfalls

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 ensure you buy a term life policy with a 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 buy-sell agreements, 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 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, the policy purchased a decade ago is likely 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 and buy additional coverage without submitting proof of good health.

Alternative to funding buy/sell agreements (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 complete buyout.

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Buy-sell agreements 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 buy-sell agreement types would suit your business.
• Make sure you pick the proper 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 critical events that could lead to restructuring 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? 

buy-sell agreements are legal contracts that allow 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 buyout and assures 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.