Part of effective estate planning is having your business planning aligned to your future goals for your family. Business owners often have a different set of considerations and complexities that necessitate more sophisticated planning. Fortunately, there are legal solutions and financial tools available to address these concerns.
If you have an ownership stake in a business, an effective planning tool that can save you a lot of legal headaches and strains on relationships—both business and personal—is a buy-sell agreement. These agreements prevent multiple financial problems that can arise upon various “triggering events” such as death, disability, retirement, bankruptcy or divorce. Buy-sell agreements provide for the sale of an owner’s business interest to the other owners or to the company itself upon the specific triggering events. Owners of any type of business entity—LLCs, partnerships, corporations, and even proprietorships—will benefit from having a clearly executed buy-sell agreement in place.
There are two basic types of buy-sell agreements: cross-purchase and redemption. With a cross purchase agreement, the remaining owners purchase the departing owner’s interest directly, usually on a pro rata basis. For example, upon an owner’s death, the other owners may have the right to purchase the deceased owner’s interest instead of taking on the deceased owner’s heirs as co-owners of the business. With a redemption agreement, more commonly found with multiple stakeholders, the business itself, rather than another individual owner or group of owners, may buy out the deceased or incapacitated owner.
In addition, buy-sell agreements can include an “option to buy” or can be structured as a “forced sale.” With an option to buy, the remaining owners or the company may have the option to purchase the departing owner’s interest. With a forced sale structure, the remaining owners or the company may be required to purchase the departing owner’s interest.
Business owners have significant flexibility in designing buy-sell agreements, which can be tailored to meet the owners’ specific needs and can be contingent upon the nature of the triggering event. In addition to the type of purchase and triggering events, a buy-sell agreement should also include provisions for the valuation of the business and funding of the potential buyout. In many cases, business owners may not have cash on hand to buy out a deceased or disabled owner’s interest. Thus, one of the most common funding mechanisms for buy-sell agreements is life insurance.
For example, let’s say that you jointly own a residential cleaning business with two other partners. You have a 50 percent stake, and each partner has a 25 percent stake, while the business itself is valued at $1 million. Let’s also say that each owner does not have the liquidity to fund a buyout with cash. In this example, you’d fund the agreement to fund the death triggering event with a $500,000 life insurance policy for yourself, along with $250,000 policies on each of your partners.
At Howes Law, we can help you navigate the specifics of executing and funding a buy-sell agreement that protects you and your family’s interests as well as those of any business partners and the business itself. If you have questions about buy-sell agreements, or any other estate or business planning issue, we would welcome your call.