What is a Buy-Sell Agreement?
One of business succession strategy is to consider a Buy-Sell Agreement. This is a legally binding agreement between the owners of a business for purchase of each other’s interest in the business. Basically, the Buy-Sell Agreement will provide for the smooth succession of the business upon the occurrence of a specified event.
Such an agreement generally provides the terms and conditions for the sale and purchase of business interests in the event of a co-owner’s death, disability, retirement, withdrawal from the business or other events.
For reasons that should be clear later on, these events are typically events which are “insured” events under the terms of insurance policies that are taken up to facilitate the Buy-Sell.
The objective of executing a Buy-Sell Agreement between the owners of a business is to help ensure that the business continues and that the outgoing owner’s beneficiaries receive the fair market price for the sale of the interest in the business.
Advantages of Executing a Buy-Sell Agreement
The Buy-Sell Agreement assures a market for the owner’s interest and addresses the concern tthat in the event of death, disability or retirement of any owner, he or his survivors would have a way of disposing of the interest in the business.
The Buy-Sell Agreement usually provides for the following terms and conditions:
- To establish an arms-length value of the business.
- To ensure that the ownership and control of the business remains with the owners or employees or heirs of the business so that it will not fall into the hands of “outsiders”.
- To preserve the right to depart from the business in the event of inability.
- To avoid continuing the business with the family of a deceased co-owner.
- To provide a market for the liquidation of an ownership interest.
- To provide a funding mechanism to pay for the purchase of an interest.
- To provide financial security for spouse or other heirs.
Main Types of Buy-Sell Agreements
If individuals are to purchase the business upon a predefined trigger event within a Buy-Sell Agreement, a Cross Purchase Agreement will be used whereas the purchase of the outstanding business interest by the business will use an Entity Purchase or shares Buy-Back Plan.
Cross Purchase Agreement
Each owner agrees with each of the other owners to purchase his share of the business at the time of death. The owners may take out a life insurance policy on the life of the other(s) to fund the obligation. At the time of the first death, the surviving owner(s) collects the insurance proceeds. The survivors then use the insurance proceeds to buy the business share from the deceased owner’s heirs.
Entity Purchase or Shares Buy-Back Plan
Each owner agrees that upon death, his share of the business will be sold back to the business. The business may buy life insurance policies on each of the owners to fund the obligation. At the death of an owner, the business collects the insurance proceeds and buys the business interest from the deceased owner’s heirs.
Factors that Affect the Choice of Buy-Sell Agreement
Cross-Purchase Agreement
A Cross-Purchase Agreement works best when the number of owners are few, their interest holdings are similar and where their age gap is minimal. In a cross-purchase agreement, each owner must purchase insurance on the other owners. With “n” owners, n x (n-1) policies are needed. For example, if there are 4 owners, 12 policies will be purchased. The maintenance and accounting becomes prohibitive as the number of owners increases.
A cross-purchase plan may be unworkable if one of the owners is elderly or in impaired health, particularly if that owner owns a large portion of the business. The policy on his life would be both large (because of the ownership share) and expensive (because of the age or health impairment).
If any of the other parties to the agreement are much younger and much less established in their careers it is unlikely they can afford the insurance premiums needed to support the Buy-Sell Agreement.
Entity Purchase or Shares Buy-Back Plan
A crucial issue for a closely held business that wishes to buy out one of its principal owners is whether it will have the funds to do so. Because few businesses have sufficient cash or other resources to fund a buy-out, the seller usually must accept payment by instalments. Instalment payments can place a burden on both parties to the transfer. The payments will drain current earnings as well as forcing the departing owner or heirs to rely upon the future success of the business where they no longer have management control.
Given these potential problems, the combination of disability and life insurance typically proves to be the least costly of these options. The most significant advantage is that complete financing is guaranteed from the beginning. A lump sum payment to the deceased owner’s estate is generally feasible only if life insurance proceeds are available to fund the payment.
When the Entity Purchase Plan is used, a business of ‘n’ owners need purchase only ‘n’ policies.
On the disadvantage side, insurability may be a problem or, due to age differences among shareholders, premiums may not be equitable. This has to be addressed with appropriate compensation measures.
The following is an extract from PreceptsGroup Succession and Trust in Wealth Management, 4 th Edition.
The following is an extract from PreceptsGroup Succession and Trust in Wealth Management, 4th Edition.
The book can be purchased here.
For more detailed explanation on this subject, Precepts Academy conducts an AEPP® Advanced Module on Buy-Sell Arrangements for Business Owners. The course details can be found here.
