Protecting Against the 4-D’s of Disruptive Events
As a business owner or partner in a business, you need to make sure you’re protected in the event of a disruptive event. A buy-sell agreement can ensure the continuity of your business and protect your own interests and your family’s in the event one of the following disruptive events occurs:
While these events may be difficult to think about, you must consider that it is inevitable one of these will happen at some point in your business. Think about the consequences of what might transpire in your business without a plan to deal with subsequent events. The result can be disastrous, leading to lost business opportunities, declining employee morale and productivity, loss of customers, etc. In addition, your family may be left without financial protection or it could result in the demise of your business.
A buy-sell agreement can apply to any type of business, whether a partnership, corporation, LLC or sole proprietorship. You want to ensure that what you have worked hard to build is protected by having the right contingency plan in place that allows your business to remain intact and on its path to success with your family protected.
Death of a Sole Owner
The most impactful disruptive event that can occur in a sole proprietorship or family-owned business is when the owner dies. Without the proper structure in place, you can leave both your family and your business unprotected.
You need to protect your family against failure of the business when you’re gone. A buy-sell agreement can detail the manner in which your heirs are to be compensated by the business, the price they should receive for their share of the business and the terms by which they are bought out.
One method of accomplishing this is by having the company purchase a life insurance policy on your life. In the event of your death, the policy will pay money to the company. The buy-sell agreement will then provide the details of how your family is to be remunerated.
The best approach is to do this through term insurance based on the shortest number of years possible. This is the least expensive method of ensuring you are covered because the value of your business changes over time. It is advisable that you review your policy every two years to ensure the value of your business is correct. In the long run, you’re protecting the value of your business for your family.
Death of a Partner
A properly drafted buy-sell agreement can establish procedures for dealing with issues that may arise in the event a partner dies without leaving any type of written plan detailing their ownership rights and what should happen to their interest in the company.
Without an agreed upon procedure to handle issues that may arise in this scenario, litigation would likely occur, which will surely impact the value of your business.
A cross-purchase buy-sell agreement dictates that each partner take out a life insurance policy on the other and the monetary value of interest owned by the deceased partner will flow to their family. In this case, a value for the business is established and a term life insurance policy is purchased. And, again, that value is reviewed every two years to ensure the policy is changed as the value of the business changes. The buy-sell agreement establishes this protection and provides for a safe transfer of interest from one partner to the next, as well as, protection for the surviving family members.
It is possible that during a person’s working life they may become disabled and unable to work. What happens when you or your partner is no longer able to participate in running the company? How long can the business pay a salary and how long before the disability should trigger a buyout of the disabled person’s interest in the business?
A disability buy-sell agreement can solve these issues by specifically outlining the types and amounts of insurance the partners should take out to cover the contingency of health-related forced retirement. It can also extend to identifying specific buyout insurance to provide a means for co-owners – or even an outside entity – to purchase the interest of the disabled owner.
This buyout generally will occur over a period of years. To establish the value of the company, we recommend utilizing the following formula: a multiple of earnings + net equity. We also recommend a provision that provides for a long-term buyout at prime interest rate to ensure the business can fund the buyout. Anything shorter than this and you run the risk of funding the buy-out with after-tax profits only. This will significantly impair your cash flow and your profitability.
In our world today, at least 50 percent of all marriages end in divorce. Frequently, divorces end in a protracted and less than amicable litigation. Without a buy-sell agreement that specifically addresses procedures for a buyout in the event that a partner is divorced, all assets of the business may be legally required to be divided 50-50, leaving you in business with your partner’s ex-spouse. In some cases, business owners have been forced to sell the business to pay for a divorce settlement. And oftentimes, the owner is required to accept a purchase offer at a discounted price.
This contingency can and should be addressed in a buy-sell agreement that specifies that the divorcee is not entitled to an interest in the business as part of the marital property and that an interest in the business cannot be transferred to the divorcee. The agreement should also provide that in the event there are inadequate assets to satisfy a divorce settlement, then a buyout is triggered to satisfy the assets inside the divorce agreement.
As in the examples above, make sure the buy-sell agreement includes a provision for valuing the company (multiple of earnings + net equity) with a long-term buyout period to ensure the business does not run out of cash. In this way, you have preserved the business and provided for a safe transition while avoiding being in business with the ex-spouse.
There are any number of reasons partners decide to leave a business. They may decide they no longer wish to work together, or one or more decide to take advantage of another opportunity.
How do you determine what is owed to the departing partner and where the money will come from to buy them out? Without a contingency plan in place, this can cause problems and result in being distracted from running the business. You want to avoid any undue recourse to methods that could damage the sustainability of your business.
Again, a buy-sell agreement should specifically set forth the procedures to follow in the event a partner leaves – whether they just want to end the business, they failed to perform, they just want to do something else, etc. The agreement will specify the payout terms of how and over what period of time a departing partner will be bought out.
Let’s guide your success . . . together. For information on how to assess the value of your company, contact us.
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• Buy-Sell Agreements Watch Video>
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• Buy-Sell Agreement—Multiple Owners Watch Video>
• Buy-Sell Agreement—Disability Watch Video>
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