A quick search on Google defines a buy-sell agreement as follows:
A buy-sell agreement, is a legally binding agreement between co-owners of a business that governs the situation if a co-owner dies or is otherwise forced to leave the business, or chooses to leave the business.
Sounds simple? It’s not.
I’m often surprised by the number of business owners I speak with, who while may be thinking of a buy-sell, may not be thinking of funding it.
The buy–sell agreement should be fully funded. The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business.
According to LIMRA, (Life Insurance and Market Research Association) only a fraction of buy-sell agreements exist as legal documents. And where there is a buy-sell agreement in place, it is often not funded.
I was recently interviewed by the Canadian Music Trade magazine, and spoke about how the absence of a funded buy-sell agreement caused a music retail store to close in my own neighborhood. http://jaimieblackman.com/canadian-music-trade-interviews-jaimie-blackman/
While personal guarantees may have been made, verbal promises from a deceased or disabled owner, which have not been memorialized in a funded buy-sell agreement, are worthless.
Tom Cosica,Esq., Partner with Andros, Floyd & Miller, agrees.
The use of life insurance proceeds to fund the buy-out provides for a guaranteed funding source for the purchase of the deceased stockholder’s shares without the need to use the future cash flow of the business to support payments to the deceased stockholder’s estate. This protects the deceased stockholder’s estate by providing a guaranteed funding source and allows for the surviving stockholders to continue to operate the business without the payments to the deceased stockholder’s estate being an added burden on the cash flow of the business.
If there is no life insurance to fund the death buy-out, the payments to the deceased stockholder’s estate could severely weaken the cash flow of the business to the point where the business could fail. It is also important to remember that if the deceased stockholder was a key employee of the business, often times the business will be trying to overcome the loss of his or her value to the company and if no life insurance is in place, the added pressure of the payments to that deceased stockholder’s estate impacting cash flow could lead the business to ultimately fail.
From the seller’s perspective, an installment sale has similar concerns. For example, the owner sells all shares to a key manager today and accepts a long term payout. The installment plan while spreading out the obligation still does not provide the cash to effect the buy out in case of death or disability. The longer the term of payments, the greater the risk. Assuming the loan is callable if buyer dies before note is paid off, how does the seller collect. A properly designed life insurance policy with the proceeds going back to the seller can certainly help create the liquidity.
How recently have you reviewed your buy-sell agreements and installment loans? As valuation increases have you increased the life insurance?
Have questions? We’re all ears.