Buy-Sell Agreements: An Effective Tool In Protecting Business Assets

By Robert J. Reaume
REBC, RHU, CLU, LIC

February 2013 – Surprisingly, few business owners understand the importance of establishing Buy & Sell Agreements (BSAs). Generally, people do not like to think of a future that does not include themselves, or a business partner, but this is an issue that prudent entrepreneurs ought to address before tragedies occur. It is important that a business be protected in case of an accident or illness and that the business has solid and unquestioned leadership in place, along with a sound succession plan.

Indeed, no business owner wants to have a disabled partner, or be in business with a partner’s spouse. This is one prime example of where buy-sell agreements come into play. In many cases using BSAs can be one of the most effective ways to protect the value of a business investment and ensure the continued operation of the business.

A BSA allows a business owner to transfer the full market value of their business interest to their appropriate heirs. The BSA maps out what will occur with the ownership of the business in the event of a voluntary or involuntary termination, a premature death, a disability, or retirement of one of the owners. Even when agreements are in place, often times they have never been funded with insurance products. A “funded” BSA ensures that there will be sufficient assets available to make certain that a smooth and timely transition will occur.

Ownership transition can be handled in an efficient manner if a BSA is in place.  In essence it is a determination that is made as to what will happen if one of these events should occur. The decisions are made before such events occur, while all parties involved are healthy and in a stable state-of-mind to make rational decisions. Any BSA that is established should be designed to guarantee that a fair and reasonable price for the business interest will be paid out to the appropriate parties.

In most instances, a BSA will create a pre-arranged market, price, and payment terms for the sale of a business interest. Most businesses have limited market potential and value. Additionally, few businesses have the cash on hand to pay out the value of a deceased partner’s equity. Loans are an option – but interest on the loan will add to the cost, and as we have seen recently, loans may not be readily available in certain market downturns when banks are not willing to loan money, especially to a business that has lost an instrumental owner.

Such pre-arranged sales will often result in the best financial outcome for all of the owners. This occurs because the options without the existence of a funded BSA may result in a forced sale, hostile takeover, closure of the business, or some other form of liquidation.

There are many examples of how buy-sell agreements can ensure appropriate financial value and significant peace-of-mind. One of my clients suffered a tragedy when its majority owner unexpectedly passed away. Because the buy-sell agreement was in place, and funded, the three minority partners were able to acquire the majority owner’s share of the business, and the deceased shareholder’s estate received the fair market value of his equity in the company.

During this difficult time, the owner who was dying of cancer, and his spouse, had the confidence and security in knowing that she would receive the full market-value of his interest and the money would be available in a lump sum paid out over a short period of time.

Additionally, we had in place a “Key Employee” life policy on the majority shareholder. This helped the company pay off a large corporate loan and survive during the difficult economic environment in Michigan (the company was a supplier to the automotive industry) during 2009. In this situation, the business successfully transferred ownership to the appropriate parties without large, on-going payments, and the surviving shareholders ended up with a business that was debt-free. The surviving shareholders said that having a funded buy-sell agreement was the most prudent business decision they had ever made.

The key to the above mentioned scenario was that the agreements were “funded.” Business owners need to be aware that such agreements need to be funded with life and disability insurance. These decisions that management makes to secure the future of such a business are critical.

These agreements can be funded with term or permanent life insurance. A benefit of term insurance is the low cost of the policies. However, the period of time that the policy will last will eventually expire. A benefit of permanent (cash value) life insurance is that the funds accumulated within the policy can be used for emergencies, capital requirements during difficult markets, supplemental retirement income, or ultimately to assist in the purchasing of a retiring partner in the likely event that death did not occur. Additionally, if the business is sold, the owners can take these policies with them for their personal estate planning.

It is best to work with your business and insurance advisors to determine how the BSA plan should be set up. Business, tax and legal issues must be addressed, such as the type of BSA, future growth of the business, operational issues and future sale of the business.

A properly designed BSA can not only assist in the transfer of a business entity to a deceased partner’s beneficiaries, but can also add to the investment (basis) of the surviving partner’s equity so that a subsequent sale of the business will result in lower taxes that are owed. Most importantly, a properly designed and funded BSA will result in peace of mind – not only when it is completed, but in anticipation of its execution.

The ultimate goal of a BSA is to provide a high level of protection and financial security to business owners, stockholders, and employees. It can be a particularly effective tool to help protect the interests of family-owned businesses.

Robert J. Reaume, REBC, RHU, CLU, LIC, is the owner of The Reaume Company, a Beverly Hills-based insurance, wealth management and employee benefits firm.