In another post, we discussed the many reasons you may want a buy-sell agreement as a business owner. A buy-sell agreement gives business owners security and structure for the inevitable event that an owner leaves the company.
It’s an unbiased, premeditated agreement between owners that meets their needs in a number of potentially stressful situations a business will encounter. Hopefully, it avoids or minimizes conflict in a stressful and emotional situation.
At it’s simplest form, a buy-sell agreement protects the business and remaining owners from an adverse circumstance affecting the departing owner.
So what exactly is addressed in a buy-sell agreement? In what situations does it take effect? What should business owners consider and address in their agreement?
First, let’s start with the basics of the buy-sell agreement.
Buy-Sell Agreement Triggers
The buy-sell agreement exists to establish a market for business owners to sell their share of the business or to buy their partner’s share. The agreement addresses how the ownership may act in certain events and as a mandate for what to do in other situations. The agreement will define triggering events and what action can or must be taken if they come to pass.
Triggering events are future events in which the owners may find themselves. In some cases, an owner may be forced to sell to their remaining partners, while in other circumstances, the remaining owners have an option to buy out the departing or affected owner.
Let’s review some typical triggers found in buy-sell agreements.
Separation or Retirement
When an owner leaves the business, they may be retiring or just walking away from the business. In such a situation, all parties involved are benefited by a premeditated roadmap for how ownership will be handled, valued, and transferred.
Whether retirement or termination, remaining owners can use the buy-sell agreement to exercise control over who they departing owner sells to and at what terms. It will outline a valuation method and typically require sale to the remaining owners.
The departing owner benefits with the knowledge a liquid market exists for their ownership shares with the remaining owners.
Without such provisions, the departing owner could sell to an outside third party and inject conflict and trouble for the business or want to leave and have no way to receive fair compensation from the remaining owners. This is a recurring theme in buy-sell planning and you will see shows up with every trigger event.
Whether expected or unexpected, the death of an owner is a traumatic event and threatens to bring a company to the brink.
Owners should have a plan in place for how the business will be valued and what will happen to the ownership of a deceased partner. This is for their own protection, as their ownership is also affected by the death of a partner.
Remaining owners may want to prevent shares from passing to a spouse or child, especially helpful if those outside parties haven’t been involved with the company in the past. Plus, the agreement establishes an agreed upon valuation by all owners that can be acted upon in the future to minimize the effect of emotions on the transaction.
Life insurance is fairly cut and dry for a buy-sell agreement, as the owners will just need to adjust insurance coverage over time to match the valuation of the business. In the process of buying buy-sell life insurance, owners have an opportunity to also purchase key man life insurance to further protect the business.
More complicated than life insurance, the disability provision in the buy-sell agreement calls for a deeper discussion.
Similarly to death, the disability of an owner challenges a company and if unaddressed, could bring it to an end. While the disability trigger is closely related to the death trigger, it has a few more complications that we need to discuss.
Besides the premeditated method to determining valuation, a disability trigger must address exactly what is considered a disability to an owner, how the buyout will be structured, and how it is to be funded.
Definition of Disability in a Buy-Sell Agreement
The definition of disability is a key point for owners to address. There must be alignment between how a buy-sell agreement defines an owner’s disability and when the disability insurance will pay a claim. Imagine owners who are called to buy out a disabled partner but due to the strict language in the disability insurance policy, they can’t receive insurance proceeds.
While a buy-sell agreement may require that ownership shares or stock be purchased if an owner dies, the disability trigger may allow owners some wiggle room and make the buyout voluntary or effective over a period of time.
The key benefit of the disability provision is it creates a liquid market for the owners to sell, if necessary.
Structure of the Disability Buyout
While life insurance creates immediate liquidity for a buy-sell agreement and supports an immediate transaction, disability is typically a more gradual event affecting an owner and business. First, the disabled owner cuts back their hours and transfers some of their workload on the other partners. As they take on less responsibility and the remaining owners are independently running the business, it may become clear that the disabled partner won’t be coming back and needs to sell.
The buyout provision for a disability reflects the possibility of this dynamic and offers remaining owners the option to buyout the disabled partner over time or at once.
The funding strategy for a disability must match the structure of the sale, so while insurance can create immediate liquidity, it can also be structured to create cash flow to the business for periodic purchases.
As with the rest of buy-sell planning, everything depends on the uniqueness of the business and the owners involved.
Underwriting Buy-Sell Disability Insurance
While life insurance can be fairly easily obtained to fund a buy-sell agreement, disability insurance can be harder to obtain. This can be due to medical reasons, as an owner may have a pre-existing condition that prevents them from qualifying for disability insurance, or financial reasons, as disability insurance can be more expensive than life insurance and harder to conform to the buy-sell agreement’s provisions.
In some situations, insurance carriers may not want to underwrite a set of owners, due to the nature of the business, the structure of the agreement, or some dynamic among the owners such as large age disparities. The agreement should reflect this reality in how it is structured, otherwise the owners can expect severe disruption during a disability.
Divorce or Bankruptcy
As we’ve discussed, the repeating theme of buy-sell agreements is protection for remaining owners and an exit plan for the departing owner, so it’s no surprise the agreement also needs to address serious legal situations such as divorce or bankruptcy.
A buy-sell agreement will usually require a divorcing owner sell their share of the business so as to prevent a non-employee spouse from obtaining ownership.
Likewise, one owner’s bankruptcy can introduce the prospect of outside third parties assuming ownership of the business. Therefore, the agreement may require disposition of ownership in the event of a bankruptcy.
Other Considerations for Triggering Events
Are there other unique, legal or non-legal concerns that can affect your business?
Perhaps the loss of a license would adversely affect an owner from contributing to the company or expose ownership to difficulty in operating the company.
As always, legal professionals can help an ownership group identify any unique situations for which their buy-sell agreement needs to address.
With the roadmap provided by a buy-sell agreement, owners can feel confident knowing they have a plan in place for the various situations the future may bring. While those events will still be difficult, a buy-sell plan can at least remove some of the struggle and argument bound to occur.
Now that we’ve addressed why owners need a buy-sell agreement and what is generally covered within the agreement, we’ll next take a look at the types of buy-sell agreements.
Our hope is that you and your fellow owners learn something of value from these posts and take action to protect your business, your partners, and yourself and your family.
Our team at the LBL Group brings decades of experience in business and estate planning and a national network of professionals to a discussion about your business and protection needs.