Choosing the Right Buy-Sell Agreement Structure for Your Client’s Business

While it’s easy to get caught up in the day-to-day tasks of running a business, often it’s the plans put in place to handle long-term potential challenges that can matter the most. When it comes to securing long-term business continuity, the process of setting up a buy-sell agreement is an essential foundational task.

A buy-sell agreement is a legally binding contract among business owners that lays out a clear process for what will happen if specific triggering events occur. Those events could include the death, disability, retirement or voluntary departure of an owner. The agreement sets the terms for the sale or transfer of ownership to other owners or third parties. Put another way, a buy-sell agreement helps ensure the smooth, orderly transition of ownership of the business after a triggering event—allowing the business to continue its operations smoothly.

Why are buy-sell agreements for closely held businesses a good idea?

Although most businesses can benefit from a buy-sell agreement, closely held businesses are particularly in need of one. Closely held businesses often feature multiple owners who share a common interest in the company…and are, very often, members of the same family. These family members rely on the business to provide ongoing income and support, but they also may wish to allow other family members to take over one day, or to have the option to sell the business upon the death or retirement of the owners. By setting up a buy-sell agreement well in advance of any triggering event, they can help put in place an orderly transition of the business during what may otherwise be a chaotic time.

Specifically, buy-sell agreements offer the following benefits:

Business continuity: Having a pre-determined plan for the transfer of business ownership will help maintain the stability and continuity of a business during the transition period. In addition, this plan can help reassure clients, business partners and colleagues in the industry that the business will carry on without interruption.

Valuation and fairness: Determining the value of the business interest being sold well in advance of a triggering event helps prevent conflicts and disagreements among owners. The reassurance of a buy-sell agreement has an underlying impact as well: a strong, well-structured agreement helps maintain the business’s value in the eyes of potential investors and future owners.

Financial security for owners and their families: A well-crafted buy-sell agreement sets up funding provisions for the transfer of ownership interests—often using life insurance as a funding tool. This type of reliable funding vehicle helps safeguard the financial security of all parties. In case of a death, for example, a buy-sell agreement protects the family of the deceased owner by providing them fair compensation for their share of the business, which can help reduce the risk of financial hardship.

Control and ownership: When owners have worked hard to build a business over time, they have a personal stake in making sure its future remains true to their original vision. A buy-sell agreement provides business owners with that control, allowing them to dictate who can become part of the company and under what circumstances.

What factors go into creating the right buy-sell agreement for your client?

There are four main types of buy-sell agreements. A redemption or entity purchase, a cross-purchase arrangement, a one-way buy-sell or a wait-and-see buy-sell. To choose the best type of agreement for your clients, consider the following:

Business entity structure: What type of business entity does your client own? Whether it’s a closely held business, corporation, partnership or LLC, there is a buy-sell agreement ideal for that entity. For example, if the entity is a corporation and the company itself is buying the ownership shares, the structure most often chosen is a redemption or entity purchase. If the business entity is a closely held business or partnership and the remaining owners plan to be the buyers, your clients may need a cross-purchase arrangement or a hybrid approach between cross-purchase and redemption.

Funding mechanism: Many buy-sell agreements use life insurance as the vehicle to fund the agreement, providing a lump sum to fund the purchase of a deceased owner’s interest in the business. Alternatively, your client could choose to set aside funds from business profits, obtain financing from a bank or leverage other financial vehicles to supply adequate funding.

Valuation method: Determining the valuation method for the business up front helps ensure fairness and head off any future disputes. These methods could include using a fixed price, arriving at a valuation via an agreed-upon formula or using a professional appraiser to set the value of the ownership interest.

Triggering events: While death is perhaps the most common triggering event for a buy-sell agreement, it’s not the only one. Disability, retirement, voluntary departure, bankruptcy of the owner or other considerations may be included in the buy-sell agreement, depending on the needs of your client and their fellow business owners.

Legal and tax considerations: It’s important to seek legal and tax advice when structuring your client’s buy-sell agreement.

Review schedule: Businesses and market conditions change over time. By setting up a regular review schedule for the buy-sell agreement, your client can help it remain relevant and aligned to the business’s needs—as well as the needs of the owners.

Buy-sell agreement examples

A carefully structured buy-sell agreement can make the difference between a chaotic transition period—including a potentially devastating loss of business revenue—and a smooth, orderly process that helps the business grow. Here are a few examples of how an effective buy-sell agreement can aid your client’s business.

Example #1: partners build a company on solid decisions

Mary and Frank (who are not married to each other) own a successful advertising business together, each serving as equal partners. Over many years, they have worked to grow the business. As the business took off, they decided to draft a buy-sell agreement to ensure that both parties were taken care of in case of a tragedy or life change.

Fast forward five years, and Mary passes away suddenly. According to their buy-sell agreement, Frank has the right to buy Mary’s interest in the business. To fund this transaction without hardship to the surviving owner, Mary and Frank bought life insurance policies. Mary is the owner and beneficiary of a policy insuring Frank’s life, and Frank is the owner and beneficiary of a policy purchased insuring Mary’s life. The proceeds from Mary’s policy received by Frank upon her death are then used to buy out Mary’s ownership interest, allowing Frank to keep full ownership and control of the agency. In addition, now Mary’s family can enjoy the financial security from being compensated for her share of the business.

Example #2: a closely held business prepares for the future

The well-established closely held family business, Zap Electronics, is a small manufacturer of computer components. Zap is owned by three siblings—Alex, Ben and Brooke. Several years ago, they drafted an entity buy-sell agreement, hoping to protect their company for decades to come. No one in Ben’s, Brooke’s and Alex’s respective families has the skill or expertise to simply step into their shoes, and they want to keep the business thriving.

When Ben unexpectedly passes away several years later, the buy-sell agreement is triggered into action. In the case of Zap Electronics, the company has the right to buy Ben’s share in the business, using the proceeds from Ben’s life insurance policy to fund the transaction. Ben’s family is well compensated and financially secure, Brooke and Alex are now co-owners in the business, and Zap Electronics continues to thrive without disruption to its operations.

Next steps for choosing the right buy-sell agreement for your client’s business

Although your business owner clients can’t predict the future, they can plan for it.  By helping them craft a buy-sell agreement that meets the unique needs of their businesses you can help them—and their families—fulfill life.

To learn more about choosing the right buy-sell structure, check out this white paper brought to you by Advanced Underwriting Consultants and the Ameritas Advanced Solutions and Design Team.

In approved states, life insurance is issued by Ameritas Life Insurance Corp. In New York, life insurance is issued by Ameritas Life Insurance of New York.