Consider Doug and John, owners of a bakery. Doug is an expert at cakes and pastries, while John’s talent is rolls and breads. They both share the load of administrative work, with Doug taking care of accounting and inventory, while John’s responsibilities include marketing, sales and payroll. If Doug were to die unexpectedly, John would likely have to hire two or more employees to fill Doug’s shoes. At the same time, Doug’s widow, now a single parent, may need to sell Doug’s share of the business to meet her family’s needs. John can hardly run a profitable business under such conditions, much less raise the funds to purchase Doug’s share of the business from his widow.
Such situations can be avoided with a properly drawn and funded buy-sell agreements. Buy-sell agreements allow owners to establish a predetermined price at which the business can be bought by the surviving owner(s) should an owner die. These agreements are often funded by life insurance policies, where the proceeds from the death benefit allow for the purchase of the deceased’s share of the business. In our example, a buy-sell agreement would allow for an easy exchange of business ownership to John, while life insurance proceeds provide the cash needed for John to buyout Doug’s business interest. This, in turn, provides funds for Doug’s family at a time when it is most needed.
There are essentially two types of buy-sell agreements: cross-purchase and entity. In both types of agreements, life insurance plays a key role in providing the funds to buy the deceased owner’s business interest.
Cross-purchase agreements are ideal for a small number of owners. Each owner of the business purchases a life insurance policy on the life of the other owner(s). Each owner pays the premiums on the policies to the insurance company, and is named the beneficiary. Should an owner die, the insurance company pays the death benefit to the surviving owner(s). In turn, the proceeds are used by the surviving business owner(s) to purchase the deceased’s share of the business at the previously agreed upon price. Insurability may be a factor, as younger or healthier owners may incur higher premiums to cover older or less healthy owners.
Companies with multiple owners generally employ entity agreements, in which the business purchases a life insurance policy on the life of each owner, with the business paying the premiums. Should an owner die, the insurance company will pay the death benefit to the business. The proceeds are then used by the business to purchase the deceased’s share at the previously agreed upon price, with surviving owners now enjoying a greater percentage of ownership. The administration is relatively easy, and the business bears the premium differences associated with owners’ insurability.
A properly funded buy-sell agreement can provide everyone comfort and security they will receive the maximum benefit from the business that they worked a lifetime to establish.
William G. Lako Jr., CFP, is an executive in residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Lako is a certified financial planner.The Marietta Daily Journal will periodically publish columns from KSU business faculty.