What is a Buy-Sell Agreement?
A Buy-Sell Agreement is a legally binding contract that lays out the parameters under which shares in a business can be bought or sold. It provides a mechanism for an orderly business succession should an owner decide to transfer his interest due to a voluntarily event, such as retirement, or an involuntary event, such as death, disability, divorce, insanity, or bankruptcy.
Why is a Buy-Sell Agreement Important?
A Buy-Sell Agreement is known as a “prenup” for business. It is typically created at the inception of a business when all of the stakeholders are generally agreeable.
A buy-sell agreement facilitates the orderly transfer of business interests when certain specified events occur. A buy-sell agreement:
- Creates a market for the departing owner’s interest in the business when no such market exists in the absence of such an agreement.
- Prevents a break in management and voting control of the business.
- Creates job stability for remaining minority owners and key non-owner employees.
- Ensures that the survivor of a deceased owner is compensated for the deceased owner’s interest.
- Enables surviving owners to purchase a deceased owner’s share promptly, thus preventing the deceased’s interest from being locked up in probate and eliminating the possibility of a personal representative of the deceased becoming a voting owner.
- Sets an accepted value for the purchase of an owner’s interest, eliminating the possibility for costly and time-consuming litigation.
- Determines each owner’s interest in the business.
All co-owned business should draft a Buy-Sell Agreement as soon as possible.
Most Common Types of Buy-Sell Agreements
The two most common types of buy-sell agreements are entity-purchase and cross-purchase agreements.
- Cross purchase – A cross purchase agreement depends on each business owner buying a life insurance policy on each of the other owners. Then, when an owner dies, the remaining owners use the payout from the life insurance policy to buy the deceased owner’s share of the business.
- Entity purchase, or stock redemption – Each employee-owner enters into an agreement with the business to sell their interest in the business. As part of the agreement, the business buys life insurance policies on the lives of each owner. The business pays the premiums and therefore exists as the owner and beneficiary of the policy. When an employee-owner dies, that share of the company passes to the heirs of his or her estate. Then the business can use the policy’s death benefit to buy the interest from the estate.
Key Elements of a Buy-Sell Agreement
A buy-sell agreement consists of the following key elements:
- Triggers and notice requirements (these are the actions that result in the right or obligation to purchase – like death, incapacity, bankruptcy, etc., and the responsibility of the partner involved in that action to notify the other partners about what happened).
- Rights and/or obligations to purchase (a buy-sell agreement can be set up to require a person to buy out the withdrawing partner or to give a person the right to buy out the withdrawing partner).
- Identification of the buyer(s) (most commonly the company itself or the remaining partners).
- Valuation, including discounts if any (a pre-agreement on the purchase price or the method of determining the purchase price at the applicable time – also sometimes buy-sell agreements provide for different valuations/methods depending on the particular trigger).
- Payment terms (application of insurance proceeds, if applicable, and the timing of payments)
- Consequences of not exercising available purchase rights (typically the buyer has a specified amount of time to consummate the purchase from the withdrawing member after which the shares may be able to be sold to a third party).
Using life insurance to fund a buy-sell agreement
A buy-sell agreement does not need a funding mechanism to be valid. The entity and its owners may have sufficient resources to pay for any interests that may be bought pursuant to the terms of the agreement. However, it is very common to fund the obligations to purchase interests upon the owners’ deaths with life insurance. The life insurance proceeds are used to purchase the deceased owner’s interest, or at least as much of it as can be covered by the insurance. This can ease the financial strain on the entity and the remaining owners.
Using Disability Insurance and the Buy-Sell Agreement
The disability provisions that should be incorporated in a buy-sell agreement are:
- income replacement,
- overhead expense payments and
- ownership interests.
Correspondingly, there are three types of disability insurance that should be considered for inclusion in the terms of your agreement:
- Disability Income Insurance. This insurance provides a monthly benefit to replace income paid to a disabled person (an owner or employee). The premium tends to run about 1 to 2 percent of the person’s annual salary for salary replacement through age 65, and the benefit is usually tax-free provided the recipient paid premiums out of his or her pocket. If the company pays the premium, the cost is generally higher, but the premium is tax-deductible for the company and the benefit is taxable to the recipient. Of course, it is expensive to simply continue paying the salary of someone who can’t contribute, even if that person is the owner. So, disability income insurance is a low-cost way to protect an asset — the owner’s income — while protecting the company’s cash flow.
- Business or Professional Overhead Expense Insurance. This is important coverage for a business with a sole owner. The disability income insurance described above replaces income but does not pay the day-to-day costs of running a business when the owner is disabled. Rent, utilities, salaries and other overhead costs don’t just go away. If there’s a chance the owner will return to the business, this insurance increases the likelihood there will be a business to come back to. If disability triggers the sell provisions of a buy-sell agreement, overhead expense payments ensure there is a viable entity to sell.
- Disability Buy-Out Insurance. If the disabled owner is unable to return to work, disability buy-out insurance can enable the business (or the buyer under a buy-sell agreement) to purchase the disabled person’s interest at a pre-determined monthly, annual or lump sum payment level. Disability buy-out insurance does not preempt disability income insurance, so the disabled owner gets a fair price for his or her business interest and continues to receive the agreed-upon disability income insurance payments.
It’s easy to skip disability provisions in buy-sell agreements — in fact, many professionals only look at buy-sell agreements as a way to maintain liquidity and pass on the business interest after the death of an owner. Yet, some statistics show that people are more likely to become disabled while working than they are to die.
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