Why Partnerships Have Buy-Sell Agreements
There are many advantages to starting a business with a partner, from the adage “two heads are better than one” to increased capital and borrowing capacity to get the ball rolling. However, once your business has begun to grow, it’s important to think about the next steps.
What would you or your partner do if one of you decided to leave the business, or if circumstances beyond your control–like disability or death–occurred? Don’t leave important decisions up to fate: have a plan in place to be sure that your business is protected should something happens to you or your partner.
Having a buy-sell agreement, also known as a buy-out agreement, in place assures that you or your partner can oversee the next steps in ownership of your business should one of you become out of the picture. Maybe you want your wife to take control of your share of the company should you pass; maybe your partner wants their son to replace them.
What The Partners Need To Decide
By agreeing on the basic stipulations before moving ahead with documentation, each partner can make a contribution to how the business will move forward should one of the leadership team be suddenly lost. Planning ahead, making decisions before an unexpected event will provide peace of mind. Free from this worry allows each partner to focus on business growth. These agreements provide for family security and give comfort to vital employees working in your organization. Do you really want to be working with a partner’s troubled son, or a cousin just our of grad school? The worst case would be a fire sale of the business for less than fair value.
No matter what type of business you own, from a mom-and-pop shop to a multi-level networking company, a buy-sell agreement is a smart choice to protect you, your loved ones, and your business’s legacy.
The Break Down
A buy-sell agreement is a legal contract. Several key steps are involved in the agreement function properly. We’ve outlined the three basic decisions to keep in mind as you move forward in creating a buy-sell agreement.
1. Establish and agree on your business’s value.
The overall worth of the business, as well as what percentage each partner holds must be agreed upon by all parties. You can choose to establish this value through a valuation formula, or simply by deciding upon set amounts.
Importantly, review the valuation annually (more often should a new client, contract or product affect income) or when the market outlook is trending positively. Align the buy-sell agreement to business sales, debt, profits, and income. Allowing too much time between evaluations may lead to a significant surprise should a partner be indisposed.
2. Choose the structure of your plan.
While there are multiple forms that a buy-sell agreement can take, the two most commonly used structures are an entity-redemption plan or a cross-purchase plan.
Entity-redemption plans require the business itself to buy out a partner’s interests, while a cross-purchase plan allows the surviving partner(s) to buy an agreed-upon percentage of the withdrawn owner’s share. If there are multiple partners in a business, an entity-redemption plan is often the most effective and efficient.
Another option, a trusted cross-purchase plan, would allow a third party trustee to oversee the plan and allocate any assets at the loss of an owner. Carefully consider which of these two makes sense for the business and partners.
3. Have funding in place.
It goes without saying that while it is important to settle upon a buy-out agreement, it is equally important to plan on funding it. How will you pay to see the agreement through if the time comes?
You will need to be able to make payments and have money readily available for use, either through an installment plan, a loan, or some other fund. Many business partners choose a life insurance policy to add a valued asset, as it’s both cost-efficient and a tax-friendly option for funding. Develop a strategy, make a plan.
Why Life Insurance Is A Leading Choice To Fund Buy-Sell Agreements
When you fund a buy-out agreement via life insurance, a policy is bought on the life of each partner either by the other partner(s) or the business itself. If a partner passes, the business or remaining owner(s) receives the death benefits from the policy.
Even though the premiums paid on the policy are not tax-deductible, in the eventual event of the policy being cashed in, the death proceeds are free from income tax. This makes life insurance an affordable way to pay for a buy-out agreement.
Additionally, choosing life insurance as your funding option allows for flexibility, as both term and permanent life insurance policies can be applied. Not sure which type of life insurance would be best for you and your business? Let us help.
Term life insurance is coverage for a set amount of time. While the coverage is temporary in comparison to permanent life insurance, the premiums are usually lower and therefore more affordable.
Permanent life insurance coverage is, well, permanent; in other words, the policy has no set time limit. In addition to offering coverage for life, permanent life insurance is a method to accumulate capital that can be applied to the business, the buy-sell agreement. Permanent life policies are a good choice for profitable partnerships in any sector or type of business. Professional partnerships to construction to medical labs, size does not matter.
An for option retirement planning. Get with an advisor willing to explore your vision. At retirement, you could name another beneficiary, use the accumulated capital for your personal needs, to fund your retirement, start a new business, or provide for your family.
Once the agreement is completed, the calm, satisfaction and joy the partners will have is well worth the short term distraction. There are choices to be made, types of life insurance to consider, valuations to be determined and papers to sign. Don’t be distracted with worry about a future financial event. Speak with your peers, start the discussions now, and find a knowledgeable qualified independent insurance agent, a trusted advisor to secure a meaningful agreement.