If you missed our prior posts about buy-sell agreements, we talked about why you may want to have a buy-sell agreement, what is included and addressed in a buy-sell agreement, and the differences between cross-purchase and entity purchase agreements.
This final post in our four-part series looks at how a buy-sell agreement can be funded.
Remember from our previous posts that a buy-sell agreement can address what happens in various common situations that may affect owners, namely the retirement, termination, retirement, disability, or divorce of an owner. Not only must owners decide what will happen in each situation, they also need to consider how such a transfer will be financed.
The most common funding options are cash flow, a sinking fund, debt, and insurance. Let’s discuss each option and it’s pros and cons below.
Funding a Buyout with Cash Flow
Buying out an owner with existing cash and cash flow can either be planned for or instead the last resort when another option falls through.
This can be a difficult method to use given the particular buyout amount and cash flow of the business. The cash flow of the business may be slightly to significantly impacted by the exit, disability, or death of an owner, and may be disrupted. And if the buyout term calls for a lump sum payment, cash flow won’t be enough to meet the buyout obligation.
For example, a business owner passes away and the business will buy $1,000,000 of outstanding shares from the deceased owner’s estate. Assuming that owner was one of three equal owners in a $3,000,000 business, the cash flow of the business wouldn’t be more than $25,000 a month. That’s not nearly enough to fund a million dollar buyout, and this example is being generous in assuming the business cash flow isn’t hurt by the loss of an owner.
The specific figures will change depending on the business and owners involved, but suffice to say, using cash flow to buyout an owner or their estate is not very viable.
Sinking Fund for Buy Sell & Buyout
Owners can save for a future buyout of an owner. This can work well for definitive future exit dates if the cash flow continues and a reasonable rate of return can be earned, to say nothing of risk if capital is exposed to loss. If the sinking fund is owned by the business, then it has the opportunity to develop a corporate asset that improves the financial position of the business and can help it obtain future financing.
However, this strategy obviously will fail to create the necessary liquid capital if an owner dies or becomes disabled and a buyout must occur today or in the near future. In such a case, the business may look to using debt.
Using Debt to Fund a Buy Sell
In theory, financing a buyout can provide the necessary capital in the exact amount whenever needed to purchase the interest of an exiting owners.
In practice, anyone who has gone to a bank for financing will tell you the process can be long, arduous, and won’t always lead to a lending approval. In particular, the lending institution will see a significant amount of risk in a business that just lost a key contributor and therefore question the business’ cash flow and debt capacity.
Given the unpredictable availability of financed capital, business owners need a more dependable vehicle to produce the sometimes six or seven figures required in certain buy sell scenarios. To do so, owners usually transfer this risk to an insurance carrier.
Insurance to Fund a Buy Sell Agreement
Insurance is a popular finance method for buy sell planning because it can be neatly designed to meet the exact exit triggers in a buy sell agreement, at a reasonable price.
While insurance does not exist for retirement or termination risk, insurance can deliver proceeds to a business to meet the exit obligations of a death or disability. And financing the risk with insurance allows cash and assets to be deployed to higher and better uses in the business, for example on capital investments, R&D, or other investments to grow the business.
Of course, the caveat is that an owner must qualify for insurance. Many factors affect insurability for a buy sell agreement, including the health, age, and financial needs of the agreement. Always work with an independent insurance agent who can compare quotes across the market for the lowest life insurance rates.
The two types of buy sell insurance address the risk of death and disability of an owner.
Buy Sell Life Insurance
At the death of an owner, the buy sell agreement will be triggered and the business (or other owners if a cross purchase agreement) will need to come up with liquid capital in short order. Buy sell life insurance is the vehicle of choice for this need. With the competitive term life insurance market today, a business can obtain Term Buy Sell Life Insurance at very reasonable rates.
While in the act of purchasing buy sell life insurance, a business may want to also obtain Key Man Life Insurance, which provides capital to the business above and beyond the needs of the buy sell agreement. This insurance can offset lost revenue, increased expenses, and other needs related to the loss of an active owner.
Buy Sell Disability Insurance
Similar to life insurance, disability insurance can be designed to meet the needs of a buy sell agreement’s disability provision.
However, there are a few more moving pieces with disability buyout insurance that we need to point out. The key questions to answer are how a disability will be defined and when the proceeds need to become available.
The Definition of Disability is a critical point to discuss. The sick or injured owner may find themselves in one of any number of scenarios. They may be able to work part time, they may not be able to perform certain key functions, or they may need to step back from the company completely. The key here is for the Definition of Disability in the insurance policy to match the definition in the insurance policy.
Additionally, the insurance policy must not only deliver proceeds in the right amount and in the right situations, but at the right time. The Waiting Period is the time between when a disability begins, and when the proceeds are payable. The waiting period for buyout disability insurance may be 180, 365, or even 720 days. It’s very important that the waiting period in the insurance policy matches the time period in the buy sell agreement. This way, insurance proceeds are delivered to the business or the owners exactly when they need to buyout the disabled partner.
By addressing these situations ahead of time and making decisions with clear heads, owners give themselves the best chance of moving through such a situation with as little conflict as possible.
As you can see, the structure of a buy-sell agreement is very detailed and nuanced. Before an agreement can be made and funded, owners must address and consider many factors.
The agreement and these questions are unique to each business and the involved owners. This series is by no means exhaustive; every business and ownership group is unique and as such, must address these questions and more with legal and financial consultation.
Keep an eye on our blog for future series and articles about topics at the intersection of employee benefits, business strategies, and technology.
If there’s anything you’d like to learn or discuss, please let us know below!
* The above information is intended to be educational only, and not advice to any particular situation. You should always consult with your legal professional when it comes to your own situation.