There’s a good chance your business will be knocked for a loop if you die or become disabled … that is unless you make plans in advance.  One option worth exploring is a buy-sell agreement.

A buy-sell agreement answers the “what if” question about what will happen to the business if one of the owners dies or becomes incapacitated.  Its purpose is to replace uncertainty and chance with specific, legally enforceable instructions. 

The buy-sell agreement, which should always be drafted by an attorney, can protect the interests of all parties:  surviving co-owners; the deceased’s family and other heirs; and other employees, who will be assured that the business will continue.  It works by providing clear directions regarding the fate of the business if the unexpected happens.  Just as important, it helps assure that the cash for a free-and-clear buyout is available.

The document itself can be as simple or complex as your situation requires.  In general, it calls for the survivors to buy — and the heirs to sell — the deceased owner’s interest.  Additionally, it either stipulates the actual purchase price or provides a formula for determining the price.

A buy-sell arrangement is appropriate in a number of situations, including:

• If you have co-owners.  If one owner dies, the others buy the deceased’s share.  The surviving owners obtain control of the business, while the deceased’s spouse and other heirs receive a fair price for their inherited share of the business. 
• If you have family members in the business.  While you may want your daughter the vice president to take over the company, there may still be the question of providing for your surviving spouse and, possibly, children who did not enter the business.  The agreement specifies that the family member who is actively involved in the business receives full control, while other family members receive their inheritance in cash. If you have a loyal non-owner employee.  An agreement can assure that (1) he or she has the right to buy the business and (2) that the money is available to make the purchase.  
• Funding considerations:  Most agreements address the issue of funding.  The reason is obvious.  When an owner dies, perhaps suddenly, the surviving owners may be bound to purchase their deceased associate’s share of the business.  This may require a huge amount of money — hundreds of thousands, perhaps millions of dollars — in cold, hard cash on very short notice.  If the money is not available, the buy-sell agreement can collapse.  The surviving owners may be forced to go into debt to meet their obligation.  In addition to the loss of their associate, they could find the business further destabilized by taking on this unexpected debt.  The agreement can quickly unravel as a result.

There are four possible funding options that can be used to carry out the buy-sell agreement:

Option # 1:  You can set up a sinking fund and build it up gradually with periodic payments over time.  Drawbacks:  As funds accumulate, they could trigger a retained earnings liability.  Also, if death occurs early, the amount would be inadequate.  Finally, it makes little sense to for most businesses to tie up what could be working capital in a hands-off fund.

Option # 2:  You can borrow the money at the time of death.  Drawbacks:  Credit can be impaired by the death of one of the owners.  Plus, repaying the debt would siphon working capital out of the business and further jeopardize its stability.

Option # 3:  You can provide for installment payments to the heirs, allowing the deceased’s shares to be purchased over time.  Drawbacks:  This strategy also places a drain on the company’s working capital.  It is comparable to continuing to pay a deceased partner’s salary for years, yet getting no value for those payments.

Option # 4: You can purchase life insurance.  Historically, cash value life insurance has proven to be one the most effective buy-sell funding options. 

Here are just some of the many advantages of using life insurance as a funding tool:

1. The money can be available in full within weeks of the deceased owner’s death.
2. Though premiums are not deductible, the proceeds are received by the beneficiary income-tax-free. 
3. The insurance is purchased with budgetable, periodic premium payments.
4. In some states, laws restrict stock redemptions, unless they are funded from company surplus.  However, life insurance proceeds are generally considered to be surplus.
5. The policy can be structured to make the cash value available to help fund a buy-out at retirement.  

The bottom line:  You owe it to yourself, your heirs and your business associates to find out more about an insured buy-sell agreement and how it can provide for an orderly transfer of your business.  There are many details to consider when designing a buy-sell agreement.  Where to start:  Contact your insurance agent.  He or she can help you analyze your situation and coordinate the involvement of other parties.

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