If something happens to you how will your business survive? And what about your family, since most likely they are depending on your income from the business? How will your heirs monetize the value of your business? A buy-sell agreement is an extremely important strategy that can address these issues.
A buy-sell agreement is a legally binding contract between two or more business partners that outlines the terms and conditions for the sale of a business interest in the event of certain triggering events, such as the death, disability, retirement, or voluntary or involuntary departure of one of the partners. The agreement helps ensure the continuity of the business and protects the interests of all parties involved.
One of the biggest challenges in implementing a buy-sell agreement is determining how to fund it. There are several options available, and the best choice will depend on the specific circumstances of the business and its owners.
Funding with Cash
One way to fund a buy-sell agreement is with cash. The partners can simply agree to set aside a certain amount of money to be used to buy out a departing partner’s interest. This method may work well for small businesses with a few partners and relatively low valuations.
The issue with this is that cash could be used for projects to grow the company and if the business value increases in the future there may not be enough cash to cover the updated valuation.
Funding with a Sinking Fund
Another option is to establish a sinking fund, where the partners contribute a certain amount of money each year to build up a pool of funds that can be allocated to buy out a departing partner’s interest. This method can be more flexible than using cash, as it allows the partners to gradually build up the necessary funds over time.
This strategy may work better than cash, however you would need to have an updated valuation done each year (this cost money) to determine how much the partners should contribute. Additionally, the cash that is contributed into the sinking funds could be utilized for other projects that could grow your company.
Funding Through Borrowing
Borrowing is another option for funding a buy-sell agreement. The business can take out a loan to finance the buyout, or the departing partner can finance the buyout with a promissory note. This method may be more expensive over time as interest will need to be paid on the loan or note.
Funding with Life Insurance
Many businesses choose to fund their buy-sell agreements with life insurance. The partners take out policies on each other’s lives, with the business named as the beneficiary. In the event of a partner’s death, the proceeds from the insurance policy are positioned to buy out the deceased partner’s interest. This method can be cost-effective, as the premiums are typically less expensive than borrowing or setting aside cash.
This is a sound approach; however, you need to understand partners insurability and if the partners are not equal partners you may want to consider who pays for the policy, either the business or each partner pay on the life of the other partner.
Another thing to consider is the amount of life insurance you take out should also factor in future value. For example, if your current value is $5 Million and there is a life insurance policy taken out for that amount, what happens if the value grows to $7 Million or $10 Million? Working with your exit planning advisory team and valuation experts will provide you with the guidance on the appropriate amounts of insurance to purchase.
Cross-Purchase and Entity Redemption
There are two basic structures for buy-sell agreements: cross-purchase and entity redemption. In a cross-purchase agreement, the remaining partners agree to buy out the departing partner’s interest. In an entity redemption agreement, the business itself buys out the departing partner’s interest. The funding method will depend on the structure of the agreement.
A well-crafted buy-sell agreement can help protect the interests of all parties involved in a business partnership. Choosing the right funding method is crucial to ensuring that the agreement can be executed in the event of a triggering event. Each funding method has its own advantages and disadvantages, and the best choice will depend on factors such as the size and structure of your business, the number of partners involved, and the overall financial situation of the business. It is important for you to consult with your Wealth Advisor who specializes in exit planning as they will provide introductions to help you with all the legal and financial professionals to determine the best approach for their specific circumstances.
