For a small business owner, their life and their business can be so entangled that it feels impossible to distinguish between the two. Years of hard work, sacrifice, and concentrated focus make a small business successful. A business owner that built an enterprise from the ground up has every reason to be proud of their work, providing income for not only their family, but often times employees as well. Now a time may come when the owner would like to retire or explore other opportunities.
- What then should be done with the viable business that was created?
- Is there an exit strategy in place for the owner to walk away?
- How can the business be passed on to a capable employee, family member, or outside buyer?
This is where some forethought is required, and with a business buy/sell agreement in place an owner can finally have the opportunity to look at life beyond business.
Overview of the Buy/Sell Agreement
A buy-sell agreement is simply a contract, typically drawn up by a business attorney, which outlines the transfer of ownership between a buyer and seller. These agreements can be made many years in advance before actually executing. If an owner would like to sell his/her business to a family member or a knowledgeable employee or even a partner, the contract would dictate under what circumstances such a transfer would occur. The actual mechanics of such a transfer can be done in a different ways; entity purchase, cross purchase, and one-way buy-sell. Let’s look at each of these options to further examine how the plans work.
An entity purchase buy-sell agreement is made between each of the business owners and the company they own. Upon the passing or retiring of an owner the company buys out the interest or stock of that particular owner. The remaining owner(s) then advertently absorb the retired owner’s share of the company. Often times the funding mechanism for such an agreement is the use of life insurance. If the owner passes away, a life insurance death benefit can be paid to the company, and the company then buys the stock from the deceased owner’s family or estate. If the owner retires, the cash value inside a permanent life policy can be used to enable or help finance the purchase of the deceased owner’s interest.
An entity purchase is a great way to ensure the survival of a company with the passing of an owner and protect the owner’s loved ones. It can also be an important way to help plan for retirement if the enterprise is the main source of retirement for the owner.
A cross-purchase buy-sell is similar to an entity purchase, but here the buy-sell agreement is between business owners as opposed to being between an owner and the company. Upon the passing or retiring of an owner the remaining owner(s) receive the death benefit of the life insurance to pay off the deceased owner’s estate/family. Similarly to an entity-purchase, if the owner is retiring the remaining owner(s) can use cash value inside a permanent life insurance policy to help fund the buyout along with traditional forms of financing or savings if needed.
A one-way buy-sell is used when an outside buyer or a non-owner wants to purchase the owner’s business. This can be done at point of death or retirement in a similar fashion to that of an entity or cross-purchase buy-sell plans. If the cash value inside the life insurance policy is insufficient to finance the retiring owner then the traditional forms of financing could become necessary. Often times the new owner would be required to pick up their own life policy to obtain financing if needed to complete the buy-sell.
Remember, a buy-sell agreement is simply the contract, normally drawn up by an attorney with the stated company value in order to complete the ownership transaction(s). A Buy-Sell does not necessarily require a life insurance plan to fund the contract, however when compared to the alternatives of 100% traditional financing or the use of business assets it often is the ONLY viable way to accomplish the arrangement. An unfunded buy sell would simply be an agreement to buy from an owner without a funding mechanism. Such negligence can be dangerous on the part of both parties as an expectation to transfer ownership could be unmet due to a lack of proper planning to obtain funds. Being proactive about business succession and retirement can allow for significantly greater options for a business owner.
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