By Robert J. Reaume
November 5, 2009
Surprisingly, few business owners and entrepreneurs understand the importance of establishing Buy-Sell Agreements (BSAs). In general, people do not like to think of a future that does not include themselves, something especially true in the business world. However, this is an issue that prudent owners ought to address before personal tragedies occur. It is important that a business be protected in case of an accident and that the business has solid and unquestioned leadership in place, along with a sound financial succession plan.
Indeed no business partner wants to have a disabled partner - or be in business with a partner’s spouse. And that’s a prime example of where buy-sell agreements come in to play. In many cases using BSAs can be one of the most effective ways to protect the value of a business investment and ensure the continued operation of the business.
A BSA allows a business owner to transfer the value of their business interest to their appropriate heirs. The BSA maps out what will occur with the ownership of the business in the event of a premature death, disability, or retirement of one of the owners. A “funded” BSA ensures that there will be the funds available to make certain that this will occur.
Ownership transition can be handled in a much more efficient way if a BSA is in place. In essence it is a determination that is made as to what will happen if one of these events should occur The decisions are made before such events occur, while all parties involved are healthy and in a stable state-of-mind to make rational plans. Any BSA that is established should be designed to guarantee that a fair and reasonable price for the business will be paid out to the appropriate parties.
In most instances, a BSA will create a pre-arranged market, price and payment terms for the sale of a business interest. Most businesses have limited market potential and value. And few businesses have the cash on hand to pay out the value of a deceased partner’s equity. Loans are an option - but will cost the interest on the loan - and as we have seen recently, may not be readily available in certain market downturns when banks are not be willing to loan money to businesses that have lost “Key Employees.”
Such pre-arranged sales will often result in the best financial outcome for the owners. This occurs because the options without the existence of a funded BSA may result in a forced sale, hostile takeover, or some other form of liquidation.
There are many examples of how buy-sell agreements can offer not just financial value but significant peace of mind. One of my clients suffered a tragedy when its majority owner unexpectedly died from cancer. Because the buy-sell agreement was in place, and funded, the three minority partners were able to acquire the majority owner’s share of the business, and the deceased shareholder’s estate received the fair market value of his equity in the company.
During this difficult time, the owner who was dying and his spouse had the confidence in knowing that she would be taken care of after he was gone and the money would be available in a lump sum paid out over a short period of time.
Additionally we had in place a “Key Employee” life policy on the majority shareholder that was utilized. This helped the company survive during this difficult economy. In this situation, the business successfully transferred to the appropriate parties, and the surviving shareholders ended up with a business that was debt-free. In this case, one of the former shareholders said that having a funded buy-sell agreement was the most prudent decision he and his partners had ever made.
Unfortunately, while these agreements are crucial planning tools, and the legal documents may be in place, many are unfunded. Business owners need to be aware that such agreements need to be funded with life and disability insurance. BSAs funded with insurance are used as a secure level of protection for business owners, successors, stockholders and employees. The reality is that many people rely on any given business for financial stability. The decisions that management makes to secure the future of such a business are critical.
An additional benefit to a BSA funded with permanent (cash value) life insurance is that the funds accumulated within the policy can be used for emergencies, capital requirements during difficult markets, supplemental retirement income, or ultimately to assist in the buying out of a retiring partner in the likely event that death or disability do not occur.
It is best to work with your business and financial advisors to determine how the BSA plan should be set up. Business, tax and legal issues must be addressed, such as the type of BSA, future growth of the business, operational issues and voluntary or involuntary termination of employment.
A properly designed BSA can not only assist in the transfer of a business entity to a deceased partner’s beneficiaries, but can also add basis to the surviving partner’s equity so that a subsequent sale of the business will result in lower taxes that are owed. Most importantly, a properly designed and funded BSA will result in peace of mind - not only when it is completed, but in anticipation of its execution.
The ultimate goal of a BSA is to provide a high level of protection and financial security to a business owner, stockholders and employees. It can be a particularly effective tool to help protect the interests of family-owned businesses.
Bob Reaume, REBC, CLU, LIC, is a partner with The Reaume Company, a Troy-based insurance, wealth management and employee benefits firm.