Business Planning Suite
The Business Planning Suite is your one stop shop for solutions to your business client’s needs. The suite includes strategy specific material, as well as general business planning materials.
Business Continuation and Structural Considerations
A buy-sell agreement is a contract that provides for the future sale of your business interest or for your purchase of a co-owner’s interest in the business. Buy-sell agreements are also known as business continuation agreements and buyout agreements.
Under the terms of a buy-sell agreement (assuming you are the seller), you and the buyer enter into a contract for the transfer of your business interest by you (or your estate) at the occurrence of a specified triggering event. Typical triggering events include death, disability, and retirement.
Ideally, buy-sell agreements are fully funded, and life insurance is frequently used for this purpose. After determining the value of the business, you, your advisors, and the other parties to the agreement will determine the best way to fund the transaction, and the triggers appropriate for your business situation.
If you own a business and are concerned about how the death of a co-owner might affect its operation, a funded buy-sell agreement can help by ensuring that you will be able to purchase your partner’s share, eliminating any doubts about the continuation of the business. You can also avoid the dilemma of being in business with your partner’s survivors.
There are also costs and possible disadvantages involved in establishing a buy-sell agreement. One such disadvantage is that the agreement typically limits your freedom to sell the business to outside parties. If you think that a buy-sell agreement might benefit you and your business, consult your attorney and financial professional about the pros and cons of setting one up.
A properly funded buy-sell agreement can:
- Provide departing owners a market and price for an asset that might otherwise be hard to sell.
- Permit remaining owners to prevent an unqualified individual from acquiring an interest in the business.
- Minimize business disruptions resulting from disagreements among owners at various triggering events.
- Provide assurances to employees, customers, suppliers and creditors that the business will remain strong through owners transitions.
Most business owners insure their physical business assets – plant, property, equipment, and inventory. They also insure against potential liabilities, which might arise out of the use of business property or customer liability arising from the business product or service.
These are insured because the risk of loss, the possibility of damage or cost, is too large for the business itself to bear. But, what about your business profits? Without future profits your business would diminish in value. Are your future profits as well insured as your assets reaped from past profits? Insure your future profits by insuring the assets who create these profits, your key people. No business asset would turn a dime of profit without somebody putting it to use. People make profits … and you insure profits by insuring the people who produce the profits.
Any successful business is a combination of three factors:
(1) Capital in the form of money, credit or assets
(2) Labor in the form of employees
(3) Management ability or entrepreneurship.
Of these, the last factor is the most important. Capital and labor can always be replaced – the last is irreplaceable. It is the key people – those who mean the difference between success and failure – who must be insured.
As was said by the U.S. Court of Appeals:
“What corporate purpose could be considered more essential than key man insurance? The business that insures its building and machinery and automobiles from every possible hazard can hardly be expected to exercise less care in protecting itself against the loss of two of its most vital assets – managerial skill and experience.”
An unfortunate result that often follows the death/disability of a business owner is the potential loss of valuable employees and subsequently, the company’s customer base. Valuable employees, who have the knowledge and skills to run the business in the absence of the business owner, are usually the most capable of securing another position in the face of an uncertain future. Additionally, customers may either follow these employees to their new companies or look elsewhere for services or supplies. Without the continued services of these valuable people, the business falters and is likely to lose its value as a going concern.
A Stay Bonus ties valuable employees to the company until the business can be either sold or liquidated or until the owner can resume his or her responsibilities after a disability.
The Stay Bonus is one of several components of a comprehensive exit strategy for business owners. John H. Brown, author of How to Run Your Business So You Can Leave it in Style © 2003, recommends a seven step program, which consists of:
1. Setting Owner Objectives
2. Determining Value/Price
3. Increasing Business Value
4. Converting Business Value to Cash
5. Transferring the Business for a Promissory Note
6. Contingency Planning
7. Wealth Preservation Planning
Life insurance may be an ideal tool to provide the liquidity necessary to fund the employer’s repurchase obligation of stock distributed to employees through an ESOP (Employee Stock Ownership Plan).
All privately held companies have a statutory obligation to purchase ESOP shares from separated employees. One of the intents of an ESOP is to provide a market and liquidity for the purchase of company stock. Thoughtful planning and funding of the repurchase liability can be a strong factor for maximizing the value of an ESOP.
Companies that fail to plan properly to meet their ESOP repurchase obligation may have unexpected disruptions in cash flow and face the following risks:
- Poor employee morale because of the uncertainty of funding
- Increased costs of capital
- Lower company value, perhaps even the failure of the company as a viable business
With proper planning, repurchase obligation issues are not difficult to resolve and are not unlike facing the liquidity needs of any closely held company.
Buy Sell Strategies
Designed for business owners who want to continue operating the business in the event of death, disability or retirement of an owner, while equalizing the benefits to heirs between the first and the last owners to die. This type of arrangement may be especially appropriate in extended family situations, where the owners expect the business to appreciate significantly over time and want each family branch to share in the potential for growth. It may also be appropriate in businesses in the early development stages, which expect to obtain significant market share from a particular technology or innovation, and want to ensure the original owners’ investment is captured for their family, should they predecease the success of the venture (by either going public or selling to the right buyer).
A No-Sell Buy/Sell arrangement provides that the management and/or voting interest in a business will pass to the surviving owners/active children, while the non-voting interest remains with a deceased owner’s family or estate. The owner also sets up an Irrevocable Life Insurance Trust (ILIT), which purchases insurance in the amount of the owner’s business interest. At death, the income tax-free proceeds are paid to the trust, securing the family’s financial future. The family retains its participation in the future appreciation of the business (through the non-voting interest), while surviving management/active children keep control.
In a cross-purchase arrangement, the owners of a business agree to purchase an owner’s interest upon the occurrence of a triggering event (death, disability or retirement). Each business owner is the applicant, owner, beneficiary and premium payor of a life insurance policy on the life of every other owner. At death, each surviving owner receives policy proceeds income tax-free. Each surviving owner pays cash to the decedent’s estate and in return receives a pro-rata portion of the decedent’s business interest. The result is that the estate’s non-liquid business interest has been transformed into cash, and the surviving shareholders own 100% of the business.
Many closely held businesses do not make formal plans to transition the business in the event of the premature death of a business owner, the lifetime transfer or sale of the business, or the retirement of one of the key business owners. Lack of planning can cause a business to fail because of the significant changes that are brought about due to these triggering events. By using a cross-endorsement buy-sell plan funded with a permanent life insurance policy, the funds required to transfer the business efficiently will be available.
A cross-endorsement buy-sell plan is a private split dollar arrangement that provides the business owner and his or her family with the liquidity needed to transfer the business when one of the business owners dies prematurely. Alternatively, since the business owner owns the life insurance policy outright under this arrangement, he or she can access the policy’s potential cash value to supplement retirement income or to fund a lifetime buyout of the business due to disability.
Moreover, the plan may also provide the estate liquidity needed in the future to account for the wealth created from the growth of the business or from a successful public offering of the company’s stock. Because of its inherent flexibility, a permanent life insurance policy is an adaptable financial tool that can address a business owner’s changing needs over time.
An entity purchase buy/sell arrangement is an agreement between the business itself and each owner. The business agrees to purchase the interest of a business owner upon a triggering event, such as the death, retirement or disability of an owner. The business entity is the applicant, owner, beneficiary and premium payor for insurance policies on the lives of each business owner in an amount that equals his or her respective ownership interest in the business. At death, the business entity normally will receive the policy proceeds income-tax-free.1 The entity pays cash to the deceased owner’s estate, and in return the estate transfers the deceased owner’s business interest. The result is that the estate’s non-liquid business interest has been transformed into cash, and the surviving shareholders own a larger share of the business.
A hybrid “wait and see” approach can preserve flexibility in deciding who should purchase the business interest upon a triggering event. The wait and-see buy/sell requires that both the business and the owners agree to purchase shares of a departing owner pursuant to the terms and conditions of the buy/sell agreement.
Generally, it is advisable to give the business the first option to purchase the shares. If the business fails to exercise its option, the surviving business owners then have a second option to purchase the shares pro rata. Finally, if the business owners fail to purchase the shares or only purchase a portion of them, the business is required to purchase the remainder. For optimum flexibility, each owner is the applicant, owner, beneficiary and premium payor for insurance policies on the lives of every other business owner.
At death, each surviving owner/beneficiary normally will receive the policy proceeds income-tax free. The estate transfers the deceased business owner’s interest under the agreement for cash. Should it be determined that an entity purchase is preferable, then the business owners can make a capital contribution to the business, using the death benefit proceeds.
The business owner identifies a potential purchaser interested in and capable of stepping in to take over the business. The potential buyer could be a family member active in the business, a key employee(s) or a third party. In a unilateral buy-sell agreement, the owner (or his/her estate) is obligated to sell the business interest in the event of death, disability or retirement, and the purchasing party is contractually obligated to buy that interest. The purchaser is the applicant, owner, beneficiary and premium payor for an insurance policy on the life of the business owner. At death, the owner/beneficiary will receive the policy proceeds income-tax-free. The estate transfers the deceased business owner’s interest under the agreement for cash.
In a trusteed cross-purchase arrangement, a trustee or escrow agent holds each owner’s stock certificates. The trustee is also the applicant, owner, beneficiary and premium payor for an insurance policy on each business owner equal to the value of his/her business interest. At the death of an owner, the trustee collects the policy proceeds and pays the deceased owner’s estate, in exchange for the decedent’s business interest. The trustee then credits each surviving shareholder’s “account” with the appropriate pro rata share of ownership of the purchased shares. By agreement, the deceased owner’s escrowed interest in the policies is reallocated to the surviving owners.
Business owners desire to continue the business in the event of death, disability or retirement of an owner. They want to use either a cross-purchase or wait-and-see buy/sell arrangement, but the number of owners and policies required makes these arrangements too complex.
The business owners form a general partnership separate from the business entity. The partnership purchases life insurance (of which it is the owner, beneficiary and premium payor) on each owner in an amount equal to the value of their business interest. Upon death, the partnership agreement “specially allocates” the life insurance proceeds to the surviving partners.1 The death proceeds are distributed to the surviving owners as a tax-free recovery of basis; each partner then uses the proceeds to pay cash to the other owner(s)’estate(s) per a buy/sell arrangement. The result is that the estate’s non-liquid business interest has been transformed into cash, and the surviving shareholders now own 100% of the business. An exception to the transfer-for-value rule2 is the transfer of a life insurance policy to a partnership in which the insured is a partner; thus, the partnership arrangement should avoid problems with the transfer-for-value rule.