Buy-Sell Agreements - Using Life Insurance to Fund Your Exit Strategy

Buy-Sell Agreements: Using Life Insurance to Fund Your Exit Strategy

Locking in your exit strategy with a buy-sell agreement can create great certainty.  The reason is that it will accommodate the continuity of your company in the broadest range of circumstances. Planning for your continuation when you or your co-owners exit is critical.  It could mean the difference between ownership transition becoming the capstone of your success or a slippery slope to financial demise.

Business Prenup: Ownership and Control When a Co-Owner Exits

If you’re in business with others, you may wonder what would happen if something happened to them, or you. What about when or if one of you wants to leave, retires, becomes disabled or physically or mentally unable to continue, or passes away unexpectedly? 

We’ve talked about how you can compensate for losing key employees or owners with Key Man Insurance, but what about the ownership interests?

Maybe you’re the sole business owner at this point, but you hope to sell someday.  If your company is built on your reputation, knowledge, and expertise, would a strategic handoff be better than an abrupt ownership change?  Perhaps it would be better to hire well as a transition strategy.  You might be able to transfer ownership slowly over several years, giving your client base time to build a relationship with the new guy.

What If You Don’t Have an Exit Strategy?

If you share the ownership of a company, your livelihood rests on its success.  How do you make sure your family members prosper, no matter what happens to you or your co-owners?

Contingency planning is one of those things that so many people put off because it’s not an immediate concern.  According to LIMRA, in 2015, 75% of US small businesses have not had their market value assessed by a business valuation expert, and 64% of US small companies don’t have a business continuation plan.

Planning for how you sell or transition can mean the difference between peace of mind or turmoil.  When your business operations continue after losing an owner without missing a beat, you and your family will continue experiencing the financial rewards of everything you’ve built. 

If the company struggles and suffers, it could mean the inability to fulfill contracts, unhappy clients, and dried up revenue.  And this could cause financial strife for you and your family. 

It’s worth thinking this through and planning for contingencies to fully experience the fruit of your labor, no matter when or how you or your business partners exit.

Tools and Ideas to Plan Your Exit Strategy

In today’s show, we discuss the buy-sell agreement – what it is, what it does, and how it works. 

We’ll answer:

Why should I plan for how I’ll exit my business?

Planning for how you’ll exit your business allows for the orderly transfer of the ownership interest when a business partner leaves the company.

Why should I plan for how I’ll exit my business?

Planning for how you’ll exit your business allows for the orderly transfer of the ownership interest when a business partner leaves the company.

What circumstances should I consider in setting up a buy-sell agreement?

A buy-sell agreement should cover any reason you or your business partner would exit the business. This includes retirement, divorce, disability, physical or mental incapacity, or death.

What is a buy-sell agreement?

A buy-sell agreement (also know as a buyout agreement) has two parts.  The first component is a legal contract that outlines what happens with the business when one partner exits.  The second element is a method of providing sufficient funding to purchase the business shares from the owner who is leaving.

Why is funding a buy-sell agreement so important?

A buy-sell agreement with no funding doesn’t provide the means to execute the plans for transfer of ownership.

What are the options to fund a buy-sell agreement?

You can fund your buy-sell agreement with cash, a sinking fund, loans, installment payments, or life and disability insurance.  Insurance solves the inadequacies of the other funding strategies by providing the most economical and certain source of capital.

How can life insurance solve buy-sell funding problems?

Life insurance can be used in three primary ways.  1) The business can own policies on the owners  2) Using a Cross-Purchase agreement, each owner would purchase a policy on the other owners.  3) With an LLC buy-sell agreement, a new entity would be set up to own policies on the owners.  If one partner passes away, the policy proceeds will pay out to provide the funds to buy out that owner’s share of the business.

You’ll gain some great ideas and insights that you maybe have never thought of before.  The further ahead you can see, the better choices you’ll make.  

Today, you’ll feel more aware of how to think about an uncertain future. And, you’ll be equipped with the questions you might need to ask yourself to chart a path forward.

Where A Buy-Sell Agreement Fits into the Cash Flow System

Buy-sell funding and agreements are just one part of a bigger journey to building time and money freedom. 

That’s why we have created the 3-step Business Owner’s Cash Flow System.  It’s your roadmap to take you from just surviving, to a life of significance, purpose, and financial freedom.

Livelihood Safeguard

The first step is keeping more of the money you make by fixing money leaks.  Then, you’ll protect your money with insurance, legal protection, and Privatized Banking.  Finally, you’ll put your money to work, increasing your income with cash-flowing assets.

A Buyout agreement is part of Stage 2.  They help you protect your interest by giving you the means to pay the buyout price and maintain control when a co-owner exits.

If you utilize a Specially Designed Whole Life Policy, your Buy-Sell Agreement can be a tool for Privatized Banking. 

And this protection also touches Unique Ability Investing, because you’re securing the market value of your company as one of your greatest assets.

Why Should I Plan for How I’ll Exit?

Options

Planning in advance gives you significant leverage because you have options.  But when you wait until the last minute, you limit your opportunity to respond.

The other day, I was driving my daughter to school.  We were about 15 minutes early, so I gave her the option to stop at a park on the way.  We deliberated a bit, but she decided she’d rather go straight to school instead.  Then, just as I was passing the entrance to the park, she changed her mind and exclaimed, “Mom, turn in!”  I considered stomping the brakes, but it wouldn’t have given time for the car right behind me to react.  Instead, I stayed committed to our original course and drove on.  Capitalizing on the teachable moment, I explained that the opportunity had passed.  When I was right on top of the situation, there wasn’t time to adjust.  I wasn’t able to make a last-minute shift, a lane change, and a screeching turn in traffic.  Knowing where you want to go allows you to plan to be in the right lane at the right time, going the right speed, and signal to other cars. 

Certainty and Peace of Mind

The same goes for setting up arrangements for business continuation in the event of an extenuating circumstance.  When you plan for how to ensure stability and continuity, even through unforeseen challenges, you gain peace of mind. 

Employees, creditors, suppliers, and customers will know what to expect if you encounter hurdles or setbacks.  They can count on day-to-day operations continuing without interruption.  And if your future is more certain, so is your family’s financial security.

Fair Bargaining

Planning for the orderly transfer of company assets gives all the owners an equal playing field in the discussion. It ensures no one has to be worried that they won’t be treated fairly. 

For instance, if one co-owner passes away suddenly, their family may have an immediate need for cash.  This can put them at a disadvantage in bargaining for fair compensation for their share.  They may be forced to sell at a lower price.  They may even sell to an outsider to force liquidation or could sue remaining owners if they feel mistreated.  The remaining business owners may then find themselves in business with someone they don’t even know who doesn’t share their vision.  Or worse yet, they may have their hands tied, unable to make critical decisions.

What Circumstances Should I Consider?

There will come a time when you will exit your business, whether voluntarily or involuntarily.  This scenario could then cause the need for a quick transfer to make all parties whole.  You should consider and plan for the big three: retirement, disability, or death, in addition to divorce and mental incapacity.

If one owner wants to retire, they could continue receiving income as an owner, but limit their working hours.  Or they may want to sell their part of the company and walk away completely.  If they’re selling their shares in the company, they’ll want a fair sale price for their years of contribution.

What if a disability prevents an owner from continuing in their role, handicapping the company as well?  The disabled owner will need income and may opt to sell their interest in exchange.

Spouses whose livelihood depends on each other insure themselves with life insurance so that if one dies, the other is taken care of financially.  The same is true in family businesses.  You share the cooperative teamwork of others to propel your company, and consequently, your income.  Because of this, your financial outcomes are dependent on others staying alive.  If they died, your livelihood would suffer.  Chances are, your co-owners spouse isn’t going to want to step into their shoes, and maybe you don’t want to be in business with their ex-spouse. 

Additionally, what if you lost your mental capacity and were unable to continue providing vision and leadership?  Or, what if your co-owner went through a divorce?  Their former spouse could lay claim to half of the value of their ownership interest.

What Are Buy-Sell Agreements?

Very simply, it is a legal contract that lays out what exactly happens when an owner exits.  It provides for the sale of the business interest when you face an event like retirement, death, or disability of one of the owners.  A buy-sell agreement establishes the market value of the business and the percent of ownership interests of each owner. 

For example, imagine Chris and Tom own a $2 Million company together, with 50/50 ownership.  Their buyout agreement outlines that if either Chris or Tom dies, retires, or becomes disabled, the ownership will transfer to the other person. That means that if one owner dies, the other ends up with 100% of the shares.

To ensure you cover all contingencies, you should draft this contract with a competent, experienced attorney.

However, a legal buy-sell agreement, no matter how articulate, has no power unless it’s funded.  That’s why a buy-sell agreement also requires the financial means to execute the sale and transfer of ownership.

Do I Need a Buy-Sell Agreement?

From the previous example, if Tom died, Chris would need to have $1M of financing to buy out Tom’s half of the company. 

Without sufficient funds, Tom’s estate would continue to own half.  That means that Tom’s heirs, whether spouse, children, or otherwise, would now own half of Chris’s company.

In that case, Tom’s heirs may not have the experience or desire to run a company.  Or Chris may dread the idea of working with Tom’s widow.

Chances are, Tom’s heirs would be much better served by liquidating their half and having the $1M cash instead. 

The ideal outcome would be that at the time of necessity, Chris has cash equal to Tom’s ownership interest and buys him out.  Chris ends up with 100% ownership of the $2 Million company, and Tom’s estate ends up with $1M cash.

What Are the Options to Fund Buy-Sell Agreements?

Buy-Sell Agreements - Using Life Insurance to Fund Your Exit Strategy

There are many options to fund a buy-sell agreement, some methods more successful than others.

Cash

You could fund buying and selling with cash.  To accommodate this, you would need to have and hold cash reserves.  However, most business’s capital isn’t sitting in a cash account.  It’s usually tied up in illiquid assets or inventory.  That means if you opt to use cash, you may end up having to sell off inventories or ending up short.

Sinking Fund

Another funding option is a sinking fund.  This allows you to set aside reserves a little at a time.  However, since you can’t predict the timing of premature death or disability, a sinking fund may not have had time to mature.

A Loan

You could decide to use a loan.  The remaining business owners would need to qualify for and obtain financing.  The difficulty here lies in the fact that creditworthiness may have suffered due to the triggering event itself and the perceived instability and uncertainty of the company.  Additionally, this adds interest to the buyout cost.

Installment Payments

Another method of funding the buyout could be installment payments to the heirs.  This is similar to seller financing.  The seller, in this case, the departing owner’s estate, receives an ongoing stream of cash flow rather than a lump sum all at once.  But the company may not be in a position to make guarantees of future payments.  If the company itself suffers, payments may dry up.

Life Insurance

Finally, life insurance policies provide the most guarantees and certainty as a financing option.  A death benefit equal to the market value of the company guarantees that at the triggering event, sufficient funds will be in place to execute the buyout.  Whether you’ve paid premiums for 15 years or only 1 month, the full death benefit will payout.  That’s why it is the most economical option to fund buying and selling agreements. 

Additionally, disability insurance can also be used to buy out the company in the case of disability.

How Can A Life Insurance Policy Solve Buy-Sell Funding Problems?

Your buyout agreement can be funded in several ways. Here are the there main types:

Stock Redemption

In a stock redemption buy-sell agreement, the company purchases insurance policies on the owners.  Upon the death of an owner, their death benefit pays out to the company.  The company can then exchange the proceeds with the departing owner’s estate for that owner’s stake in the compnay.  The company ends up with the stock, and the estate ends up with the cash.  The remaining business owners now own 100%.

Here are the pros and cons.  You would need only one policy per co-owner.  However, the surviving co-owners wouldn’t receive a step-up in basis.  That means they’d pay capital gains tax on the portion of the business they received from their partner if they later went on to sell.

Cross-Purchase

A second way to set up a buy-sell agreement with insurance is a cross-purchase.  Here, each co-owner purchases policies on the others.  For example, Tom and Chris buy policies on each other.  In the event of Tom’s death, Tom’s policy pays out to Chris, who is the owner and beneficiary of the policy.  Chris uses the cash to buy out Tom’s shares.  Again, both parties are made whole.

The cross-purchase buy-sell agreement allows the recipient of the company shares to get a step-up in basis.  The downside to this arrangement is that it can get a little bulky and cumbersome.  Because each co-owner buys insurance on each of the other co-owners, if there are three or more co-owners, multiple policies are needed on each person.  

LLC Buy-Sell

The LLC buy-sell is a third option that facilitates a more straightforward transfer when there are three or more owners.  With this model, a new LLC that mirrors the same ownership interests of the original business entity would purchase a policy on each owner. 

Here, each person gets a step-up in basis, and only one policy is needed for each owner.  Additionally, policies could change ownership without triggering a taxable event.  However, you would add in the administration of maintaining a new entity.

Buy-Sell Agreements: How to Get Started

Here are a few questions you can use to start thinking through your needs for buy-sell planning:

  1. Are there multiple owners?
  2. Is there a contingency plan for what happens if one of the owners becomes disabled or dies?
  3. If another owner dies, do you want to continue in business with their heirs?
  4. Will your co-owners take care of your family financially?
  5. Will your family receive a fair price for your share of the business?

Once you’ve determined the need for a buy-sell agreement, the next step is to do a professional business valuation.  This will determine the current value of each partner’s share of the ownership.  That value of the business will then be the baseline for how much funding is needed to substantiate your buyout agreement.

Multitasking Life Insurance to Indemnify Multiple Threats at Once

Because insurance is multifunctional, the policies used for your buy-sell agreement could also accomplish other goals.

If you wanted to retire or leave at will, the policy ownership could be transferred to you as a part of the purchase price.  You could then access the cash values through income-tax-free loans and withdrawals.

Perhaps one of your co-owners (or all of them) also plays a vital role in the company.  You could use the same company-owned policy as a Key Man Life Insurance Policy and the funding for your buy-sell agreement all in one.  If the need arose, the insurance proceeds would cover the business’ need to fill the role.  At the same time, it would also accommodate buying back the stock ownership from their estate.

Additionally, a policy set up as an Executive Bonus Plan could then be used in a one-way buy-sell agreement where the key employee buys out the existing owner.

Additional Considerations

A buy-sell agreement isn’t a set-it-and-forget-it plan.  It’s an adaptable arrangement that should be just as alive as your company.  Once you have your buy-sell agreement in place it is important to revisit the funding level periodically to increase funding over time to keep pace with a growing company. 

Depending on the circumstances, insurance may be one part of the funding source that you supplement with other financing.

Also, while you can certainly use term insurance, its payout is limited to the timeframe of the policy.  For example, after the ten years of a 10-year term policy, you’d need to set up another insurance policy or establish another funding source. 

A whole life policy is best because of the guarantees and predictable cash accumulation.  It also opens the door to use the same policy for Privatized Banking.

Buy-Sell Agreements and Infinite Banking

An additional strength of a Buyout Agreement is that it can be a storage house for Privatized Banking. 

If you use a Specially Designed Whole Life Policy, the policy owner will have a store of capital because of the guaranteed cash value. Depending on how you’ve set up the buy-sell agreement, this could provide either the owners or the company itself with access to a substantial reserve account. 

And the unique leverage point of a Privatized Banking system is its uninterrupted compounding. Your money continues to grow and compound inside the Privatized Banking system, even while you use the capital somewhere else. That’s because Privatized Banking is a platform to earn returns in two places at the same time. That means your money goes further and does more.

Getting Started with Buy-Sell Agreements

I hope we’ve opened a door for planning and potential exit strategies that leaves you feeling empowered with one less question mark. 

The one thing that is most important to take away from this conversation is the need for planning ahead. If you want to ensure the continuity of your business, a buy-sell agreement funded with insurance may be your ideal solution.

To start the conversation and find out what’s possible, book a call with our advisor team.  We’ll help you navigate your exit strategy and continuation needs. You’ll also get the one next thing you need to do on your path to accelerate time and money freedom.

Rachel Marshall

Rachel Marshall is the Co-Founder and Chief Financial Educator of The Money Advantage and President of Marshall's Insurance and Financial Services. She is known for making money simple, fun, and doable. Rachel has built a team of licensed professionals (investment advisors, insurance agents, attorneys, tax strategists) to help her clients create time and money freedom with cash flow strategies, Privatized Banking, and alternative investments. Rachel is the co-host of The Money Advantage podcast, the popular business and personal finance show. She teaches how to keep more of the money you make, protect it, and turn it into cash-flowing assets.
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