In our series of articles on succession planning, we have discussed why succession planning is so important for owners of closely held businesses. Specifically, we discussed the potential consequences of failing to plan for succession, the two distinct phases of succession planning, and how owners can build value in their businesses to maximize the sale price.
Another critical aspect of succession planning is making contingency plans for how your business would continue if you died unexpectedly or became disabled and could no longer run the company. One way for partnerships to plan for these possible events is to create a buy-sell agreement.
What is a Buy-Sell Agreement?
A buy-sell agreement is a formal legal document that helps ensure the smooth transfer of your business should one of these unfortunate events happen. In addition, it also spells out the terms for the sale of your business interest at a pre-arranged price should you die or become disabled.
If there is no buy-sell agreement in place, this could lead to conflicts (and possibly even litigation) between your surviving business partners and your heirs. In a worst-case scenario, your surviving spouse could end up as a partner-owner in the business, even if he or she has little interest in or knowledge of the business and no real desire to actively participate in it.
With a buy-sell agreement in place, your ownership interest in (and control of) the business will be transferred in an orderly fashion — whether this is to your surviving partner(s), key employee(s), an outside buyer, or your heirs. This provides a higher level of certainty and more peace of mind for all of your key business stakeholders, including:
1. Your surviving spouse and heirs - They will be fairly compensated for your ownership interest at a price that is established (and agreed upon by all parties) well ahead of time. This eliminates the potential for disputes between your spouse and heirs and your partners about the value of your interest.
2. Your surviving business partners - They don’t have to worry about becoming partners with your spouse or heirs if your spouse/heirs have no knowledge of the business or interest in actively running it.
3. Your employees - They don’t have to face the uncertainty and worry that can result in either of these two scenarios above. This can help provide greater long-term stability for your business by boosting employee retention and productivity - especially among your key employees, who might be a part of your succession plan.
Funding the Agreement
Most buy-sell agreements are funded with cash-value life insurance or a disability buyout policy. This avoids the potential problems that can arise with a so-called “sinking fund,” in which partners agree to voluntarily set aside money to buy a disabled or deceased owner’s shares, or if partners simply borrow the money to buy the shares. A buy-sell agreement funded by life insurance can take one of two forms:
One of the critical steps in drafting a buy-sell agreement is determining a binding value for the business that all partners can agree on. This is usually done by hiring a professional to perform a business valuation at the time of the agreement’s drafting. The valuation should then be updated on a periodic basis as business circumstances change.
- A cross-purchase agreement - This type of agreement usually works best when there are only two or three partners in the business. Each partner would purchase a cash-value life insurance policy on every other partner. If any partner dies, each partner would then use the proceeds to buy his or her business shares.
- An entity purchase agreement - This type of agreement usually works best when there are more than three partners in the business. Instead of partners buying life insurance policies on each other, the business entity would buy policies on each partner. If any partner dies, his or her shares would be bought by the business and then divided among the surviving partners.
- Ensure that your company's leadership and culture support and reinforce the appropriate and desired results and behaviors.
A Flexible Document
In fact, it’s critical that the buy-sell agreement itself be reviewed by all of the partners periodically and updated as necessary. The agreement should be drafted in such a way that it’s flexible enough to accommodate each partner’s (and the business’) changing circumstances over time.
To discuss the critical role of a buy-sell agreement in your business succession plan in more detail, give us a call at (800) 773-7100 or Contact Us and request that a Relationship Manager contact you.