Buy-Sell Agreements — 6 Important Questions

Exit planning is a necessary step that every business owner must eventually take. In a survey, 58% of small business owners stated that they have no plan in place for when they leave their business. The majority of them, 78%, cited the overwhelming amount of time and energy required to manage their business as the main reason for not having a plan in place.

With the average age of small business owners being around 50, the future of these businesses is at risk due to unforeseen events such as death, disability or retirement. To protect themselves and their businesses from potential failure, many business owners have turned to buy-sell agreements as a solution. A buy-sell agreement is a legally binding contract between co-owners that outlines the process and steps for purchasing a co-owner’s share of the business in case of voluntary or involuntary departure.

1. What advantages can I gain from a buy-sell agreement?

Every business owner will eventually leave their business, whether by choice or not. However, only a small percentage of business owners, 40%, have a buy-sell agreement in place. This is a concerning statistic. In many instances, a business is the most valuable and significant asset a business owner has. If something happens to one of the primary owners, it is crucial to consider the impact it will have on the surviving beneficiary, other owners, and the business itself. Such as:

• In the event that something happens to your business partner, would you be prepared to run the business with their surviving beneficiary?
• Are you willing to share the business with the deceased partner’s beneficiary?

A buy-sell agreement can provide clarity and certainty for the future of a business and its partners in these situations.

2. What is a “triggering event” in a buy-sell agreement?

A triggering event in a buy-sell agreement refers to a situation where a primary owner becomes disabled or passes away. Ideally, a buy-sell agreement should have a provision for what happens in the event of the death of a primary owner. But, it is also important to include a clause that addresses the scenario of incapacitation of a primary owner. It’s important to consider how the incapacitation of a primary owner could affect the sales, value, and growth of the business. It’s also important to think about the potential outcome if the owner never returns to the business.

3. How is the buy-sell agreement financed?

The buy-sell agreement is often financed through the business when it is exercised. There are various methods to achieve this, but often the most cost-effective way is through the use of an insurance policy. However, only a small percentage of owners report that their existing buy-sell agreements are funded through life insurance (35%) or disability insurance (18%). This means that in the event of an owner’s death or disability, most companies must purchase the owner’s share using funds from the business cash flow or by some other method. However, if both owners are protected with an insurance policy, the business would not have to bear the cost of such an incident. This method of financing a buy-sell agreement is crucial in shifting the risk from the business to an insurance company.

4. Is a valuation of the business necessary for a buy-sell agreement?

A valuation of the business* can be crucial when discussing a buy-sell agreement. It can provide insight into the worth of the business and help determine the best course of action after a triggering event occurs. Furthermore, if there is no provision in the buy-sell agreement requiring an updated valuation of the company, the surviving owner may be obligated to pay the amount stated in the original agreement, even if it does not reflect the current value of the company. Another factor to consider is that the value of the company may change after a primary owner leaves the business. It’s important to understand how the value of the company is affected by its current organizational structure.

5. Is a buy-sell agreement personally guaranteed?

If the business collapses as a result of the death of a primary owner, it is crucial to be aware of the liability of the surviving owners to pay the surviving beneficiaries based on the initial agreed amount. Knowing whether or not an agreement is personally guaranteed will give you an understanding of the potential risks you may face in case the business shuts down.

6. Who can assist you with creating a buy-sell agreement?

Seeking guidance from a reputable attorney and CPA is crucial in creating a comprehensive buy-sell agreement.

Though it may be difficult to plan for events that may not happen in the immediate future, death, disability, and retirement are eventualities that should be addressed before they become a reality. A buy-sell agreement can be tailored to address those realities and, with the help of experienced legal and tax advice, can be an effective way to secure the future of your business after you leave it. Additionally, determining how ownership interests can be distributed, transferred, or shared can also be crucial in avoiding conflicts between partners, family members, and other beneficiaries.

If you are interested in learning more about buy-sell agreements, and whether it’s suitable for your company, contact us and speak to an advisor today.

Our experienced life insurance professionals are also available for planning assistance and questions.