Why is succession planning so important for family business owners? On the long list of considerations, business continuity, family harmony, alignment between estate and succession plans, and potential estate tax reduction techniques rank high. But one essential — and perhaps overlooked — component that helps secure the future of a family-owned business is a buy-sell agreement. Why? Absent a will, ownership interest in the business could be tied up for years in the probate process upon the death of an owner, making it challenging for surviving owners to keep the business going. And death isn’t the only thing that can stop a business in its tracks: disability, divorce, or retirement of a key person can be just as devastating. In any of these instances, a buy-sell agreement could be the right solution.
Here are some commonly asked questions about buy-sell agreements and the role they play in succession planning for your privately owned company.
What is a buy-sell agreement?
A buy-sell plan is a legally binding agreement between business owners that lays out what will happen to each owner’s share of the business upon a triggering event, such as a disability, divorce, retirement, death, or forced resignation from the business. A properly structured and funded buy-sell agreement enables an orderly transfer of the business.
What can trigger a buy-sell agreement?
Buy-sell agreements can be written to cover any situation that causes an owner to exit the business. Most commonly, they’re set up to be triggered when an owner:
- Dies or becomes significantly disabled.
- Gets divorced.
- Retires from the business.
- Is forced to resign from employment with the business.
Why does my family business need a buy-sell agreement?
A well-crafted buy-sell plan ensures that the remaining owner or owners have a blueprint and just as importantly, the legal authority — to keep the business up and running. Importantly, for family-owned businesses, a buy-sell plan provides a buyer for an owner’s shares and protects remaining owners from the sale of controlling ownership interest to an outside buyer.
A buy-sell plan also sets a selling price. Since price is initially determined and agreed upon while all owners are active in the business, it helps eliminate valuation disputes when an owner leaves. Without a buy-sell agreement, an owner or their heirs may receive less than fair market value for the business they’ve helped to build.
What’s included in a buy-sell agreement?
Your buy-sell agreement provides instructions for how the business will continue and who will control it moving forward. The document also details the options for the remaining owners to facilitate the buyout of the portion of the business owned by the one who isn’t continuing with the business.
Depending on the situation, a buy-sell should at least detail the following:
- Who are the parties to the agreement?
- Who currently owns equity in the business, and what’s each owner’s percentage of ownership?
- Who has the right to purchase the departing owner’s shares of the business?
- What are the triggering events, and how are they defined?
- What is the business valuation, and how was it determined?
- What is the date of valuation?
- If financed, what are the payment terms including the interest rate assumption, frequency of payments, and the length of the note?
How often should we review our buy-sell agreement?
Because the role of a buy-sell agreement is to ensure that ownership interest remains with the existing owner or owners after a triggering event, it makes sense to review it whenever a triggering event may be on the horizon. Some events are foreseeable, such as when an owner approaches retirement age, is considering marriage, or has been diagnosed with a potentially life-shortening illness. It might also make sense to review your agreement if you’re considering a merger or acquisition that could change your ownership structure.
If no triggering event appears likely anytime soon, consider reviewing your buy-sell agreement annually — perhaps even more often if the business is enjoying rapid expansion or revenue growth that could impact its valuation.
What are the different types of buy-sell agreements?
Though there are various ways to configure buy-sell contracts, they tend to fall into three broad categories:
- Entity purchase. In an arrangement between an individual owner and the business, the business agrees to pay the owner or their estate an agreed-upon amount for the owner’s interest upon a triggering event.
- Cross-purchase. In a cross-purchase buy-sell arrangement, each owner agrees to personally buy the interest of the others upon a triggering event.
- Wait and see. The most flexible type of buy-sell plan is a hybrid of entity and cross-purchase models that allows remaining business owners to decide, at the time of the triggering event, whether the business or the owners should purchase the interest. It generally gives the business the right of first refusal.
What type of buy-sell plan is best for my business?
Buy-sell plans aren’t one-size-fits-all. The type that’s right for you depends on several factors, including:
- How your business is structured (is it a sole proprietorship, a partnership, a C corporation, S corporation, or an LLC?)
- How many owners there are?
- Who the buyer will be — will the company itself buy out the departed owner? Or will the buyer be some or all the current owners, an unrelated third party, or a business entity?
How are buy-sell agreements funded?
Without a buy-sell agreement, there may not be enough liquid cash available for the firm to buy out the departed owner, and remaining owners may not be able to come up with enough on their own — especially if the company’s valuation has risen substantially.
That’s why buy-sell agreements typically include a funding mechanism such as a company-funded or a self-funded life insurance policy for each owner.
Other funding methods include an installment sale, using cash from current working capital, borrowing from a third party, or a sinking fund. Each funding method has its advantages and disadvantages and should be examined carefully when you’re deciding which is appropriate for your business.
It’s important to note that the buy-sell agreement itself doesn’t necessarily guarantee that the funding will be in place, so it’s critical to plan ahead to make sure the transaction can be executed when the time comes.
Prioritize a holistic succession plan
As the saying goes, “failing to plan is planning to fail,” which is why your business should make succession planning a priority. Part of that means having an up-to-date buy-sell plan in place, especially in today’s economy, as inflationary pressures may have changed your company’s valuation or made it harder to accumulate the capital needed to buy out a departed owner. And with a multitude of considerations when determining which buy-sell plan is best for you, it’s always best to work with succession planning and wealth experts.
The material contained in the herein is for informational purpose only and is not intended to provide specific advice or recommendations for any individual, nor does it take into account the particular investment objectives, financial situation or needs of individual investors. Consult your financial professional before making any investment decision. The information provided has been derived from sources believed to be reliable, but is not guaranteed as to accuracy. Valmark Securities supervises all life settlements like a security transaction and its’ registered representatives act as brokers on the transaction and may receive a fee from the purchaser. Once a policy is transferred, the policy owner has no control over subsequent transfers and may be required to disclosure additional information later. If a continued need for coverage exists, the policy owner should consider the availability, adequacy and cost of the comparable coverage. A life settlement transaction may require an extended period to complete and result in higher costs and fees due to their complexity. Policy owners considering the need for cash should consider other less costly alternatives. A life settlement may affect the insured’s ability to obtain insurance in the future and the seller’s eligibility for certain public assistance programs. When an individual decides to sell their policy, they must provide complete access to their medical history, and other personal information.
