Buy-Sell Funding: Making Sure the Business Survives the Owner
For many business owners, the business is their largest asset.
It may represent decades of work, hundreds of employees, valuable customer relationships, intellectual property, real estate, and a significant portion of the owner's personal net worth.
But what happens to that business if one of the owners unexpectedly dies?
Without a plan, the answer can become complicated very quickly.
A buy-sell agreement can establish what happens to an owner's interest when certain triggering events occur. But having an agreement is only half the equation.
The agreement tells you what is supposed to happen. Funding provides the money to actually make it happen.
That's where buy-sell funding becomes so important.
What Is a Buy-Sell Agreement?
Think of a buy-sell agreement as a contract between business owners that establishes the rules for transferring ownership.
It can address events such as death, disability, retirement or other circumstances that could cause an owner to leave the business.
For example, imagine two partners each own 50% of a company.
If one partner dies, the surviving partner probably doesn't want to suddenly become business partners with the deceased owner's spouse or children.
At the same time, the deceased owner's family may depend on the value of that business interest.
A properly structured buy-sell agreement can provide a solution:
The surviving owner buys the deceased owner's interest, and the deceased owner's family receives the agreed-upon value.
Everyone knows the rules before the crisis occurs.
But there is still one enormous question:
Where does the money come from?
The Funding Problem
Let's say a business is worth $10 million.
Each partner owns 50%, making each interest worth approximately $5 million.
If one partner dies, the surviving owner may have a contractual obligation to purchase the deceased owner's $5 million interest.
That's a lot of money.
Does the surviving owner have $5 million sitting in cash?
Probably not.
Could they borrow it?
Possibly—but borrowing $5 million immediately after the death of a key owner may not be particularly attractive, especially if the business itself is experiencing disruption.
Could the family simply keep the ownership interest?
That may create a completely different set of problems.
This is why funding should be considered at the same time the buy-sell agreement is created.
Life Insurance as a Funding Mechanism
One of the most common approaches to funding a buy-sell agreement is life insurance.
The basic concept is relatively straightforward.
If Partner A and Partner B each own 50% of a business, they may establish an arrangement where each partner's life is insured for an amount designed to help fund the purchase of their ownership interest.
If Partner A dies, the appropriate party receives the insurance proceeds.
Those proceeds can then provide liquidity to purchase Partner A's business interest according to the terms of the buy-sell agreement.
Instead of asking:
“Where are we going to find $5 million?”
the business owners have already established a source of liquidity specifically for the event they are planning for.
Cross-Purchase vs. Entity Purchase
There are several ways to structure a buy-sell arrangement.
Two common structures are a cross-purchase arrangement and an entity-purchase arrangement.
In a cross-purchase arrangement, the individual owners generally agree to purchase the ownership interest of an owner who dies or otherwise triggers the agreement.
In an entity-purchase arrangement, the business itself purchases the departing owner's interest.
The appropriate structure depends on the number of owners, the type of business, tax considerations, ownership structure and other circumstances.
For that reason, buy-sell arrangements should be coordinated with qualified legal and tax professionals.
What Happens Without Funding?
This is where a lot of business owners get caught.
They have a beautifully drafted agreement sitting in a drawer.
Then something happens.
The agreement says the surviving owner is supposed to purchase the deceased owner's interest for $5 million.
But nobody has $5 million.
Now the parties have a problem.
The surviving owner may have to borrow money.
The business may have to distribute cash.
The family may have to accept installment payments.
The business interest might need to be sold to an outside party.
Or the parties may simply find themselves negotiating the terms of a transaction while grieving the loss of a partner.
None of these outcomes is necessarily ideal.
A buy-sell agreement without a realistic funding strategy can be like writing a check without checking the bank account.
Valuation Matters Too
Funding isn't just about buying insurance.
You also need to determine how much the business is worth.
Suppose the agreement was created when the company was worth $4 million.
Ten years later, it's worth $15 million.
If the insurance coverage was never reviewed, the funding may be dramatically insufficient.
That's why business valuation and insurance funding should be reviewed periodically.
The value of the business can change.
Ownership can change.
Debt can change.
The number of partners can change.
The financial needs of the owners' families can change.
And the buy-sell arrangement needs to keep up.
Don't Just Plan for Death
Death is probably the most obvious trigger, but it isn't necessarily the only one worth planning for.
Depending on the agreement, buy-sell planning can address events such as:
Retirement.
Disability.
Voluntary departure.
Divorce.
Bankruptcy.
Loss of professional licensing.
Or other events that could create an ownership transition.
The funding mechanism may be different depending on the triggering event.
Life insurance is particularly suited to funding an obligation created by death, while other sources of liquidity may be necessary for other events.
Again, the point is to design the funding strategy around the actual agreement.
Protecting Both Sides
A well-designed buy-sell arrangement isn't simply about protecting the surviving business owner.
It's also about protecting the departing owner's family.
The surviving owner wants certainty that they can continue running the company.
The deceased owner's family wants certainty that the ownership interest they inherited has value and can be converted into liquidity.
A properly structured agreement can help accomplish both.
The business stays in the hands of the people who know how to operate it.
The family receives the economic value they were expecting.
And the transition happens according to a plan that was established before emotions and circumstances complicated the situation.
The Most Important Time to Fund a Buy-Sell Is Before You Need It
Business owners spend enormous amounts of time thinking about how to grow their companies.
They think about revenue.
Employees.
Marketing.
Acquisitions.
Expansion.
Debt.
Profitability.
But one of the most important questions can be much less comfortable:
“What happens if one of us isn't here tomorrow?”
A buy-sell agreement answers the legal and contractual question.
Funding answers the financial question.
You need both.
Because the ultimate purpose of buy-sell planning isn't simply to determine who owns the business after an owner's death.
It's to make sure that the business can continue, the surviving owners can remain in control, and the departing owner's family receives the value that owner spent a lifetime building.
Don't just have a plan for who gets the business. Have a plan for how they're going to pay for it.
This article is for educational purposes only and does not constitute individualized legal, tax, accounting, financial or insurance advice. Buy-sell arrangements are highly fact-specific and should be drafted and reviewed by qualified legal and tax professionals. Insurance coverage and funding strategies should be reviewed periodically as business values, ownership and circumstances change.
