If you’re in business with a partner or partners, what happens if one of you dies, becomes disabled, departs the business or there is a dissolution?
Without a buy-sell agreement in place, the remaining partner could be left in business with a surviving spouse, an unwanted third party who doesn’t know the business, or be forced to sell when he or she is unable to come up with the money to buy out a departing partner, says Douglas Sockman, CFP, ChFC, CLU, a financial adviser with Skylight Financial Group.
“If you don’t have a buy-sell agreement in place, you need to consider getting one,” says Sockman. “And if you have one in place but it hasn’t been reviewed in recent years, or you haven’t considered how to fund the agreement, that needs to be addressed as well.”
Smart Business spoke with Sockman about how to create a buy-sell agreement, what areas should be addressed and how to fund it to help ensure you can follow through on its terms without bankrupting the business.
What is a buy-sell agreement?
A buy-sell agreement is designed to protect against the transfer of a business to unwanted third parties, provide a market for the company, help peg estate tax value and can help sever financial dependency. The buy-sell agreement is going to define what happens when one of the four D’s, a triggering event, occurs: death, disability, departure or dissolution. The agreement will spell out, if any one of these events happens, how you protect the interests of each of the partners. There is an agreed-upon formula for what happens, what value is received on all sides and how that value is received.
How can a buy-sell agreement be funded?
That is where people run into problems. They have an agreement in place, but they haven’t considered how it will be funded. For example, if there are two partners, and the formula states that the value of the business is $1 million, and one partner passes away, how does the other come up with $500,000 cash to pay the estate for that half of the business? That can put a significant strain on a business.
The easiest way to fund is with life insurance, or disability insurance. With such a policy, you are leveraging premiums to buy insurance, which can give you an instant influx of cash in the case of a death or disability. It’s an easy solution because premiums are affordable, relative to suddenly having to come up with a significant amount of money.
Without insurance, the remaining partner may have to sell the business or transfer part of it to a third party, such as a surviving spouse or child. The remaining partner also may have to take loans or dip into personal assets, and the partners need to consider whether they have those assets to buy out the other party.
If you don’t want to buy insurance, you could use assets from the company, if those assets are there, or cash flow. You could also set aside money from the business to cover a buyout, but what happens if the cash isn’t there? Let’s say you’ve agreed to an installment sale and there is going to be a stream of payments over time to buy out shares. This can pose a significant risk. What if the business falls on hard times, and the remaining partner needs to pay $100,000 a year for shares? That partner is left in the same position of having to come up with the cash.
How can having an agreement in place help with estate planning?
Owners often try to downplay the value of their business when it comes to planning for estate taxes. But the IRS will audit the business, and if it feels you’ve been intentionally low in setting the value of the business, it will not accept that value.
However, if that value has been predetermined ahead of time, and you can say, ‘Here’s the formula for valuing the business,’ that helps you arrive at a realistic market value that can help satisfy the IRS. And knowing that value ahead of time, you can look at whether you are subject to estate taxes or unnecessary income taxes and plan accordingly today, versus after a death or disability has occurred.
Can business partners create a buy-sell agreement on their own?
They really need outside involvement to put together an agreement. Typically, the agreement is drafted by an attorney, and it’s a good idea to have a financial adviser involved, as well, to make sure the funding mechanism is working.
With your advisers, look at how the agreement is going to work and how you are going to fund it. Then it’s all spelled out ahead of time and there aren’t any surprises should one of these triggering events occur.
Additionally, the agreement should periodically be revisited as the wishes of the partners and the value of the business change.
What would you say to a business owner who doesn’t see the value in planning accordingly?
Death and disability are the more common reasons for leaving a business, but what if you want to retire? You want to sell your shares and get out of the business while you’re still healthy, but what is the mechanism to exit while you’re still alive? If business owners don’t want to plan for the inevitable, then how do you plan for your retirement? How do you get out of the business? What is the formula, and where do the dollars come from?
These matters never become urgent until it’s too late. Being proactive in planning for the four D’s will prevent you from being unprepared if and when these matters do become urgent.
Douglas Sockman, CFP, ChFC, CLU, is a financial adviser at Skylight Financial Group and a member of their Advanced Planning Team specializing in personal financial planning and serving small business owners. Reach him at firstname.lastname@example.org or (216) 592-7316. Douglas Sockman is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. Supervisory Office: 1660 West 2nd Street, Suite 850, Cleveland, OH 44113, (216) 621-5680. CRN201302-145047