Match buy-sell agreements to business owners’ objectives
The wishes and needs your business-owner clients express during initial planning will help determine which type of buy-sell agreement to recommend and how to best fund it.
Buy-sell agreement considerations
The groundwork for a buy-sell agreement is presented when a business owner develops a comprehensive exit plan and begins transferring management responsibility to someone else. As a financial professional, you can provide valuable guidance during this process. Just as important, the owner’s actions and decisions will assist in determining which type of buy-sell agreement will work best.
Of course, the main purpose of every buy-sell agreement is to make sure the successor has the necessary funds to buy out the business, or interest or shares of the owner, when the time comes. The chosen successor can be:
- An existing partner or co-owner
- A family member who has shown interest in the business
- A talented employee with the potential to learn and grow
- A competitor
- An outside buyer wanting to enter the industry or business
Another important factor that shapes the buy-sell strategy is the choice of successor. During exit planning, some owners may be ambivalent about the chosen successor, or they may present obstacles that delay designation of any entity. This offers an opportunity to discuss several types of buy-sell agreements.
Cross purchase buy-sell agreement
This type of buy-sell arrangement (with a partner or co-owner) defines the price and terms at which a business owner (or partner) will sell shares to another in the event of a death, disability, or scheduled departure. If two partners or co-owners share management responsibility, each creates a separate buy-sell agreement to buy out shares of the other at a triggering event.
Example: When Owner A dies or becomes disabled (triggering events), Owner B is required to pay Owner A’s spouse or heirs a stated amount of cash equal to their business interests or outstanding shares. This cash is available immediately through proceeds of the life insurance or disability income insurance policy funding the agreement.
Benefit to Owner A: “You can be confident your spouse or heirs won’t inherit a business to run. You can turn your full business equity into cash they can use to help maintain their lifestyles.”
Benefit to Owner B: “If your co-owner dies or becomes disabled, you will have the assurance of clear buy-out terms and funding to acquire his/her shares. You won’t inherit a spouse or other third-party heirs as unwanted partners.
Entity purchase buy-sell agreement
In an entity purchase buy-sell agreement, the company (“entity”) itself agrees to buy the shares of a deceased, disabled, or retired owner or partner. This arrangement works best to simplify terms and funding for entities with multiple owners or partners, especially when there is disparity in age or health condition, and planned exit dates between owners. It can also be a good choice for an owner seeking flexibility to groom several potential successors before deciding on the most talented.
Example: When Owner A dies or becomes disabled, the entity receives the proceeds from the insurance company, and in turn, pays Owner A’s spouse or heirs for their business interests or shares. The corporation now holds Owner A’s former stock as treasury stock, and Owner B now owns all outstanding shares of the entity.
One-way buy-sell agreement
This arrangement is useful when an owner of a solely owned business who has no other co-owners or partners wishes to groom a younger family member or key employee as a successor. The business can bonus to the heir-apparent to fund the agreement. Since it is unlikely the older owner will ever need to buy shares from the counterparty, the agreement is considered “one-way.”