What Is a Buy-sell Agreement and Why Does My Business Need One?

Not only can life insurance be a great employee benefit, it also has a more business-centric use designed to ensure the smooth continuation of the company should key players suddenly pass away.

You may not be familiar with buy-sell agreements, but this is a key term when it comes to understanding how life insurance for businesses works.

Below, we will define buy-sell agreement, dig into the nuts and bolts of how one works, and briefly explain why you may need one.

What Is a “Buy-sell Agreement?”

A buy-sell agreement, also called a “buyout agreement,” is a contract that is funded by a life insurance policy that helps to prevent major problems should a key business owner or partner suddenly be out of the picture.

The agreement may apply not only in the event of a partner’s death but also (depending on the agreement’s terms) upon the sudden disability of that person for other reasons or the unexpected departure of that individual from the company.

There are several major types of buy-sell agreements, including:

• A cross-purchase agreement. In this setup, you have a business with multiple owners, each of whom take out a life insurance policy on the other owners. The benefit paid out when an owner passes away is used to buy out that partner’s interest in the company.
• An entity purchase (stock purchase) agreement. In this case, it is the business itself that buys a life insurance policy on each owner. Upon the death of a covered owner, the business can use the death benefit to purchase that person’s share of the business.
• A “wait-and-see” agreement lets the business owners avoid choosing which of the two above-named types of buy-sell agreement they want until a later date.

In general, a buy-sell agreement is a component of a comprehensive succession plan for a corporation. It helps the business continue without serious disruption even if/when one or more of its current key players pass away or can no longer perform their current duties.

How Exactly Does a Buy-sell Agreement Work?

The next question that naturally comes to mind is “How does a buy-sell agreement work? What does it include?”

The first major element that a buy-sell agreement includes is a list of buyers or potential buyers of the stock owned in a company by an owner who has recently passed away. As mentioned above, this will either be stipulated as the other owner(s), the business itself, or be left on a “wait-and-see” basis for the time being.

Typically, the heirs of the deceased must first offer the stock to the remaining owners, who in turn, are obliged to accept the offer and buy it. It may be permitted that the stock be sold to a different party, but it can also be stated in the agreement that such a new owner (“outsider”) would not get equal control of the business vis-a-vis the other original owners.

A business valuation must be done to establish the fair market price of each owner’s stock in the company. There is usually a provision for a year-by-year increase in value or a periodic reappraisal. A predetermined formula will use this business valuation to calculate the value of a deceased owner’s share.

The buy-sell agreement will also specify the “triggering events” that can lead to the buyout. These would be things like the death, disability, divorce, retirement, or bankruptcy of an owner. In some cases, the mere desire of an owner to sellout his share is allowed as a trigger.

Although there are other possible funding methods for the agreement – and the agreement must specify the funding source, life insurance or disability insurance are the usual sources.

Finally, we should mention that the buy-sell agreement will specify how much agreement is required for a buyout action. This is normally set at 80% to 100%.

What Are the Business Benefits of a Buy-sell Agreement?

It should already be apparent at this point, to a degree, what are some of the reasons that buy-sell agreements are put in place. However, it will still be helpful to briefly list the major benefits of a buy-sell agreement:

1. The peace of mind of knowing the business you have given much of your life to help build should be able to continue after you and other partners eventually pass off the scene.
2. A plan of business succession is established ahead of time that everyone agrees to. This can help make any future transitions smooth and devoid of major disputes.
3. Guarantees you have a market for selling off your share in a business at fair market value.
4. Ensures that the business will remain under the control of the current owners or those of whom they approve. This prevents a “takeover” by an unfriendly entity.
5. Gives a degree of security to a business’ creditors, workers, and clients. This may encourage them to continue dealing with your company over the long term.
6. Offers various tax advantages, including establishing the fair market value of the company for IRS purposes.
7. Allows the heirs of the deceased owner to gain cash to pay for final expenses and other expenses that the loss of a loved one may incur.
8. Is easy to fund with a life insurance or disability insurance policy.

To learn more about how buy-sell agreements or to talk to an experienced broker to establish a buy-sell agreement and/or business life insurance policy, contact Flagler Financial today!