You and your business partner have spent years building something together. You know the customers. You know the employees. You know who handles sales, who handles operations, and who knows where all the bodies are buried.
Then one of you dies.
Who owns the business now?
Depending on how the business is structured and what agreements are in place, your deceased partner's ownership interest may ultimately belong to someone who never intended to be your business partner at all: a spouse, children, an estate, or perhaps several beneficiaries.
Suddenly, you're running a company with people who may know very little about the business but understandably expect to receive the value of what they inherited.
A Buy-Sell Agreement Solves Half the Problem
A properly structured buy-sell agreement can establish what happens to an owner's interest when certain events occur, including death.
It can answer questions such as: Who has the right or obligation to buy the deceased owner's interest? How will the business be valued? When must the purchase occur?
Those are important questions. But there is another one:
Where does the money come from?
The Agreement Doesn't Put Cash in the Bank
Suppose two partners each own half of a company worth $1 million. One dies. The surviving owner—or the business, depending on how the agreement is structured—may need $500,000 to purchase the deceased owner's interest.
The agreement may say exactly what should happen. It does not magically produce $500,000.
Without funding, the surviving owner may have to borrow the money, drain company cash, sell assets, or negotiate installment payments with a grieving family. Any of those choices can put additional pressure on a business at exactly the wrong time.
The Solution: Fund the Agreement Before You Need It
Life insurance can be used to provide the liquidity needed to carry out a buy-sell agreement.
Depending on how the arrangement is designed, the owners or the business purchase policies intended to provide funds when an insured owner dies. The death benefit can then provide cash to complete the purchase contemplated by the agreement.
In our $1 million company example, properly coordinated coverage could provide the $500,000 needed to purchase the deceased partner's 50% interest.
The insurance benefit provides the cash.
The deceased owner's family receives value for the ownership interest.
The surviving owner retains control of the company.
The business has a better chance of continuing without a forced sale or sudden cash crisis.
That's the part that turns an estate-planning document into an actual business-continuation strategy.
Which Buy-Sell Structure?
There is more than one way to structure a buy-sell arrangement. In a cross-purchase arrangement, the owners generally agree to purchase each other's interests. In an entity-purchase arrangement, the business generally agrees to purchase the departing owner's interest. Other structures may also be appropriate.
The right design depends on the number of owners, business entity, tax considerations, ownership goals and other circumstances. The legal agreement and the insurance funding should be coordinated rather than created independently.
And Don't Put It in a Drawer
The business should be valued periodically and the agreement and insurance reviewed along with it.
A buy-sell agreement and insurance coverage established when the company was worth $400,000 may leave a substantial gap ten years later if the company is worth $2 million.
Changes in ownership, debt, profitability and the owners' personal circumstances can all affect the plan.
So the strategy isn't simply, Get a buy-sell agreement.
It's this:
Determine what the business is worth. Decide what should happen if an owner dies. Put the legal agreement in place. Fund the obligation. Review it as the business grows.
One Question Worth Asking
If your business partner died tonight, could you write a check tomorrow for their share of the company?
If not, you don't necessarily have a buy-sell problem.
You have a funding problem.
And that's one problem that can often be addressed long before anybody needs the money.