BUSINESS INSURANCE: THE HOW’S AND WHY’S OF A BUY SELL AGREEMENT
As in my article last week I mentioned that most all of us neglect to plan for natural disasters that may disrupt our business. This week I want to shed light on another risk our business faces: the loss of the owner or proprietor. Or in another manner of speaking, your employees wake up one morning to find the boss is deceased and will not make it back to work… ever.
What will happen to the business, the employees, and the family now? You have worked hard building your business and it has become the largest single asset and biggest income producer on your balance sheet. You are no longer with us and you were the driving force that made everything at the business happen. Will your business continue? Will your employees stay? Will everybody involved pillage your business and client base? Does your spouse know what to do? Does your spouse know where every asset of the business is? What is valuable? What is not? Should your spouse continue the business without you? Do you have an employee that can successfully continue the operations? Do you have someone who is willing to buy your business? I know what you are thinking…. way too many questions. But you do know they need to be addressed.
BUY SELL AGREEMENT
One solution is a binding buy sell agreement. A buy sell agreement is a plan that details what will happen to your business in the event of your death or disability. It is a legal agreement between yourself and a second party.
QUESTIONS TO ASK
Let us talk about your untimely death. The three main questions to address are:
- Who is the most likely candidate to take over and run the business?
- What is the value of the business?
- Once you know the value, how do you fund it?
The most likely candidates to take over the business are: your partner, a faithful employee, or a family member who has been involved with the business. The value of the business is going to be determined based on the type of business and market value.
The least expensive way to fund a buy sell agreement is a life insurance policy. Most small businesses use term life insurance. There are other options, but we will stick with term life since it is simple, cheap and easy to understand. This article is not written to go over the pros and cons of term vs. whole life vs. universal life vs. variable life. For example, You would purchase a term life policy for $250,000 if your business is worth $250,000. You may want to increase the face amount of the policy to $300,000 to allow for some short term cash needs. There are two primary ways to pay for the policy. The company can pay the premium or if you have someone who is a party to the agreement there can be a cross purchase arrangement. A cross purchase agreement is when each party pays for the others insurance premium and is the beneficiary of that policy. Simultaneously with the issuance of the life policy(s) you need a legal agreement drawn up by an attorney. All parties of the agreement must sign and execute the agreement. Do not draw one up and let it sit in a drawer gathering dust.
I would like to give you a real life case study, myself. I have a long time partner in investment properties. We have a buy sell agreement established so that we would not burden our wives in the event of one of our deaths with the responsibility of property ownership and management, and to release each other from the burden of working with our wives. We agreed upon the amount of the insurance, the type of insurance, and cross purchase payment. We had a legal agreement drawn up by an attorney and executed the agreement.
Now for the funny part: when I presented the documents for my wife to sign, Texas is a community property state, my wife who is wary of me sticking things under her nose to sign inquired as to what she was signing. I explained to her that if I died my partner would take the life insurance proceeds and buy her interest in the properties from her and she would have no worries about managing the properties and vice versa if my partner died. She looked at me in a very calculated manner and asked “what if both of you die?” I quickly explained to her that she and the other spouse would win both the money from the insurance proceeds and still own the property…More Money, right? So far she has not knocked me off.
Disability is the trickier part of the equation. We all have a much greater risk of being disabled rather than dying too soon. In the best of worlds a disability insurance policy will solve most of the financial problems. But realistically, not everyone is able to be insured for reasons of health, job vocation, and actual benefits received vs. premium paid. The legal agreement addresses the issue of disability. It documents the formula for buy out of the owner, terms of the buy out and timeliness of such. The owner may be disabled but may still be able to carryout their duties to the business and a buy out may not be necessary. These are the tougher questions to be answered in the agreement.
The important issue is to address the issue. Have in place a written plan of action. Have a buy sell agreement in place long before you need it. It can be changed and adjusted as you and your business grows. A buy sell agreement is better than a prepaid funeral plan.
Corey N. Callaway
Investment Advisor Representative