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June 22, 2021 Article 4 min read

The departure of an owner or partner can put a business’s future at risk. Buy-sell plans are crucial to ensure your company is well prepared. We explain.

Business professional taking a phone call in their home office.The success of a business depends on its stakeholders and the departure of one or more of these individuals can have a lasting, detrimental effect — especially without adequate planning. Designing a continuation, or buy-sell, plan is a crucial step to ensure the business remains intact and is well prepared for the future.

A buy-sell plan is a formal contract among business owners that lays out what will happen to each owner’s share of the business upon a triggering event, such as disability, retirement, or death. A properly structured and funded buy-sell agreement enables an orderly transfer of the business and helps answer questions such as:

  • How will the business continue?
  • Who will control the business?
  • Can/will family members of the deceased or disabled owner get involved?
  • How will the continuing owners finance the buyout of the owner who is no longer there?

Benefits of a buy-sell plan for business owners

A buy-sell plan provides a guaranteed buyer for an owner’s shares and protects remaining owners from the sale of a significant interest to an outside buyer. It also sets a fair selling price, since price is initially determined and agreed upon while all owners are active in the business, which helps eliminate valuation disputes when an owner leaves. Buy-sells lay the groundwork for identifying the liquidity needed to transfer shares from one party to another. Without a buy-sell, an owner (or their family) may receive less than fair market value. Finally, and perhaps most importantly, buy-sell agreements provide peace of mind and help maintain harmony.

A buy-sell plan provides a guaranteed buyer for an owner’s shares and protects remaining owners from the sale of a significant interest to an outside buyer.

Common types of buy-sell plans

Several types of buy-sell plans exist, and the one you choose will depend on several factors.

  1. Entity purchase. This is an arrangement between an individual 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.
  2. Cross-purchase. Each owner agrees to personally buy the interest of the others upon a triggering event.
  3. Wait-and-see: This is a hybrid of entity and cross-purchase models. It lets the business owners wait until a triggering event occurs and decide at that point whether the business or the owners should purchase the interest. It generally gives the business the right of first refusal.

Factors such as the business structure (C corporation, S corporation, LLC, etc.), number of owners, and life insurance ownership structure should factor into the decision about which type to use.

Funding a buy-sell agreement

Buy-sell agreements need a funding mechanism to ensure liquidity is available to carry out the plan if a triggering event occurs, without causing financial hardship to the parties involved. The primary sources typically include self-funded, company-funded, or life insurance. 

Life insurance often is used to fund buy-sells because it can provide immediate liquidity to buy-out one’s interest upon death, ensuring the family receives a cash inheritance while also allowing the remaining owners to continue to run the business.

Other funding methods include 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 to use.

Important considerations for creating buy-sell agreements

As you think about the future of the business and establish your plan, it can be helpful to consider the following:

  • Who are the parties to the buy-sell, and who has the right to purchase shares of the business?
  • What are the triggering events, and how are they defined? For example, how long and to what extent must an owner be disabled before a sale must occur?
  • What is the valuation methodology, and what is the date of determination? Some of the more common methods include:
    • Fixed price — should be adjusted over time.
    • Book value — can ignore the entity’s earnings potential.
    • Capitalization of earnings — value is determined by multiplying earnings by a capitalization factor, generally obtained by analyzing the price-to-earnings ratio of comparable businesses in the same industry.
    • Formula — a combination of book value and capitalization of earnings or other metrics.
    • Appraisal — may come closest to true fair market value but has a cost and can delay the settlement process.
  • What are the payment terms? Payments can be immediate, within a certain number of months or years, or a combination of both. If funded on installments, what’s the interest rate assumption, the frequency of payments, and the term?

A well-drafted and adequately funded buy-sell plan is an important part of a business owner’s succession and estate plan. Review it regularly and make any needed changes. Establishing a plan is good for business: It can bring owners peace of mind, assure families will be taken care of, and position your company for the future.

Have questions about your buy-sell agreement? Feel free to contact us. We’re happy to help.

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