DeNoble Financial Services
Funding Buy-Sell Agreements
Funding Buy-Sell Agreements
Buy-sell agreements are put into place to anticipate one partner leaving the business, either through death or other circumstances. Since in Texas, the business share is common property, the share of the partner no longer in the business is now in the hands of his/her family. You might not see them as a valuable business partner since they don’t have the knowledge and experience of your partner in the business.
The problem with many buy-sell agreements is they are drawn up early in the business and aren’t funded then, or are funded, but at a very low value for the business. Having the agreement but no money for you to buy the partner’s family out is going to be a problem, unless you have the cash on hand personally.
Funding a buy-sell plan can be done in 3 ways, and each has their benefits and potential difficulties. First, let’s look at a potential situation. A $5,000,000 business isn’t a large business by any means, but to come up with $2,500,000 to buy out a partner’s share will be a challenge. Self funding a plan is one way and doesn’t require any money being spent now, but the problem of having the funds available right when they are needed is a great drawback for this type of funding and a reason why it often fails and leads to all kinds of problems for a business and the families.
A second way is through a loan when the partner dies or is disabled or retires. Again, the benefit now is no money spent. The drawback is multifaceted. Without a key person in the business, the bank doesn’t see it as viable as it was and now, if they lend, the terms will not be optimal. Secondly, you have lost a key person and it is likely that the business won’t be growing right after the loss of the person. The debt can be real problem at that time, and a financial drain on the business.
A life insurance policy is the third way to fund it. Of the 3 ways- self funding, bank loan or insurance- it is the easiest by far to achieve and it funds the full value from day one. There are different types of policies that can be used. Depending on the business, the cash flow, the profitability and other situations based on markets, the appropriate policy can be chosen. No one looks forward to using the policy. The death or disability of a partner is devastating enough. The payment from the policy ensures that you are able to put yourself in the best position to move on. Your own money is intact, you don’t have a loan to pay and you now own all the shares and don’t have to worry about someone coming in with very different ideas.
Term policies can be used for this need, but aren’t the only one, or always optimal. The drawback is that as the company grows and becomes more valuable, the policy face values aren’t able to keep up with the new need. Secondly, there is no cash value and if the key person/partner retires, there is no funding for purchasing the shares. Universal life policies are often used because they allow you to adjust the premium you are paying, thereby increasing the value of the policy. There are limits to funding, but it works for years. Both whole life and universal life policies have cash value that builds up and can be used to purchase the retiring partner’s shares. The policy can also be a source of cash to cover other needs, such as equipment or expansion, or payroll, or other needs. Having a source of cash without going to the bank can be a real asset.
Different types of buy-sell agreements can be used. Cross Purchase plans are common for businesses with two or three shareholders. When there are more, the Business Entity or Share Redemption plan works well, as well as when partners are significantly different in age or health. Wait and See is a hybrid type of plan, typically funded as a cross purchase but leaving it open for the business to purchase the shares depending on the circumstances at the time of need.
Accurate valuation of your business is very important in establishing the need for the buy-sell agreement. It is also important for liability and other commercial insurance. To get a business valuation for anywhere in the Houston area, or to get more information on funding buy-sell agreements, call us. We have a stress test available for use for you to see how ready you are for a need to actually use the buy-sell agreement.