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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 business exit strategy with a buy-sell agreement and funding it with life insurance can create great certainty.  The reason is that it will accommodate the continuity of your business in the broadest range of circumstances. Planning for your business continuation when you or your business partners exit is critical.  It could mean the difference between business transfer becoming the capstone of your success or a slippery slope to financial demise.

Planning for Business Ownership and Control When a Partner Exits

If you’re in business with a partner or several, 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 the business for losing critical employees or owners with Key Man Insurance, but what about the ownership interests?  Will the others continue in business, sell it, or bring in a new partner?

Maybe you’re the sole business owner at this point, but you hope to sell the business someday.  If your business 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 the success of your business.  How do you make sure your family prospers as your business prospers, no matter what happens to you or your business partner?

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 haven’t been professionally valued, and 64% of US small businesses don’t have a business continuation plan.

But planning for how you sell or transition your business can mean the difference between peace of mind or turmoil.  When your business continues after losing an owner without missing a beat, you’ll enjoy continued client relationships, revenue, and growing business value.  You and your loved ones will be able to experience the financial rewards of everything you’ve built. 

But if the business struggles and suffers, it could mean the inability to fulfill contracts, unhappy clients, dried up revenue, and declining business value.  And this could cause financial strife for you and your loved ones. 

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 partners exit.

Tools and Ideas to Plan Your Exit Strategy

In today’s show, we’ll discuss buy-sell agreements – what they are, what they do, and how they work. 

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 to fund a buy-sell agreement in three primary ways.  1) The business can own policies on the owners  2) Using 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 life insurance 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.  Business continuation shouldn’t be an unknown that leaves you feeling powerless.  Instead, it should empower you with a long-term view of your business.  The further ahead you can see, the better choices you’ll make. Then you’ll gain more peace about all the decisions you make today. 

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 Buy-Sell Agreements Fit into the Cash Flow System

Business continuity, exit strategies, and buy-sell funding 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.

Buy-sell agreements are part of Stage 2.  They help you protect your interest in your business by giving you the means to buy out the business to transfer ownership when a partner exits.

If you utilize a Specially Designed Whole Life Insurance 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 value of your business as one of your greatest assets.

Why Should I Plan for How I’ll Exit My Business?

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 the stability and continuity of your business, 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 business future is more certain, so is your family’s financial security.

Fair Bargaining

Planning for the orderly transfer of business assets gives all the partners 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 business partner 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 of the business.  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.  Remaining 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 business 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 of business assets 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 hours working in the business.  Or they may want to sell their part of the company and walk away completely.  If they’re transferring the business assets, they’ll want fair sale price for their years of contribution.

What if a disability prevents an owner from continuing in their role, handicapping the business 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 of business partners.  You share the cooperative teamwork of others to propel your business, and consequently, your income.  Because of this, your financial outcomes are dependent on that partner staying alive and continuing to provide their intellectual capital to propel your business forward.  If they died, your livelihood would suffer.  Chances are, your business partner’s spouse isn’t going to want to step into their shoes, and maybe you don’t want to be in business with their spouse. 

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

What Is a Buy Sell Agreement?

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

For example, imagine Chris and Tom own a $2 Million business together, with 50/50 ownership.  Their buy-sell 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 partner dies, the other ends up with 100% ownership of the business.

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

However, a legal 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 business ownership.

Why Is Funding a Buy-Sell Agreement So Important?

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

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

In that case, Tom’s heirs may not have the experience or desire to run a business.  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 of the business and having the $1M cash instead. 

The ideal outcome would be that at the time of necessity, Chris has cash equal to Tom’s half of the business 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 a Buy-Sell Agreement?

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 a buy-sell with cash.  To accommodate this, the business or business owners 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 the business, either in illiquid assets or inventory.  That means if you opt to use cash to fund the buy-sell agreement, 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 business or remaining owner 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 business.  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 business 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 provides the most guarantees and certainty as a buy-sell financing option.  A death benefit equal to the value of the shares 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 pay out.  That’s why life insurance is the most economical option to fund a buy-sell agreement. 

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

How Can Life Insurance Solve Buy-Sell Funding Problems?

Your buy-sell agreement can be funded by life insurance in several ways. Here are the there main types of buy-sell agreements:

Stock Redemption

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

Here are the pros and cons.  You would need only one policy per business owner.  However, the surviving 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 life insurance is a cross-purchase.  Here, each owner purchases life insurance on each other.  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 share of the business.  Again, both parties are made whole.

The cross purchase agreement allows the recipient of business 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 owner buys life insurance on each of the other owners, if there are three or more 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 percentages of the original business 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.

How to Get Started Setting Up a Buy-Sell Agreement

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

  1. Do you have multiple owners of your business?
  2. Is there a contingency plan for what happens if one of the owners becomes disabled or dies?
  3. If another business owner dies, do you want to continue in business with their heirs?
  4. Will your business partners 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 will then be the baseline for how much funding is needed to substantiate your buy-sell agreement.

Multitasking Life Insurance to Indemnify Multiple Threats at Once

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

If you wanted to retire or leave the business 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 owners (or all of them) also plays a vital role in the business.  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.

When you want to exit the business and sell it to your partners, they could access the cash values on the policy they own as a funding source.

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 business 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 business.  Once you have your agreement in place it is important to revisit the funding level periodically to increase funding over time to keep pace with a growing business. 

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

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

Permanent insurance will not only give you the security that whenever death may occur, the funding will be available.  It also gives you additional functionality because of the cash value component. 

Whole life insurance 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 Buy-Sell Agreements is that they can be a storage house for Privatized Banking. 

If you use a Specially Designed Whole Life Insurance 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 business owners or the business itself with access to a substantial reserve account.  Either way, you could then use these funds as a source of capital to fund opportunities for growth.

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 a Buy-Sell Agreement

I hope we’ve opened a door for planning and potential exit strategies that leaves you feeling empowered with one less question mark.  And hopefully, that clarity is enough for you to take action to strategically protect your business, your livelihood, and your peace of mind. 

The one thing that is most important to take away from this conversation is the need for planning ahead.  Your business exit will be that much more successful and profitable with effective planning way ahead of time.

If you want to ensure the continuity of your business, a buy-sell agreement funded with life insurance may be your ideal solution.

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

Success leaves clues.  Model the successful few, not the crowd, and build a life and business you love.

Rachel Marshall

Rachel Marshall

Rachel Marshall is the Co-Founder and Chief Financial Educator of The Money Advantage. She is known for making money simple, fun, and doable. Rachel helps 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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