As a business owner, you’ve likely invested countless hours and resources into building your company. But what happens if something unexpected occurs—like the death, disability, or retirement of your business partner?
Without a plan in place, these events could leave your business in turmoil. That’s where a buy/sell agreement comes in.
A buy/sell agreement is a legally binding contract that outlines what happens to a business owner’s share of the company in case of major life events. Without one, your business could face costly legal battles, unwanted new partners, or even collapse. By setting clear terms in advance, you can protect your company’s future and ensure a smooth transition, no matter what life throws your way.
Let’s explore how buy/sell agreements work, the types available, and how life insurance plays a key role in securing your business.
What Is a Buy-Sell Agreement?
A buy/sell agreement, also known as a buyout agreement, is a legal contract that outlines how ownership of a business will be transferred in the event of a significant event, such as the death of an owner.
The key purpose of a buy/sell agreement is to prevent disputes and protect the business from uncertainty by setting clear terms for ownership transfer before any issues arise.
While a buy/sell agreement itself is not a form of insurance, it is often funded by life insurance policies taken out on the owners to ensure the necessary funds are available when needed.
This agreement is particularly important for partnerships, closed corporations, and other small businesses where ownership is closely held. However, it can be used for any type of business entity, including limited liability companies (LLCs).
Types of Buy-Sell Agreements
There are several types of buy/sell agreements that business owners can choose from, depending on their structure and specific needs. Each type of buy/sell agreement has its advantages and potential drawbacks, so it’s important to choose the one that best fits your business’s needs and structure.
Here are the most common types:
Cross-Purchase Agreement
In a cross-purchase agreement, each business owner agrees to buy the ownership share of a departing or deceased owner. Typically, life insurance policies are used to fund the purchase, with each owner holding a policy on the others.
This type of agreement works well in businesses with a small number of owners since it requires each owner to personally buy out the shares.
Entity-Purchase Agreement
In an entity-purchase agreement, also called a stock redemption plan, the business itself buys back the ownership shares of a departing or deceased owner.
The business typically takes out life insurance policies on the owners and uses the proceeds to fund the buyout.
Wait-and-See Agreement
The wait-and-see agreement combines elements of both cross-purchase and entity-purchase agreements, offering flexibility.
When an ownership transition occurs, the business and the remaining owners decide who will purchase the departing owner’s shares. Initially, the business has the option to buy the shares, but if it chooses not to, the remaining owners can do so.
Benefits of Buy-Sell Agreements
A well-crafted buy/sell agreement offers numerous advantages that can protect both your business and its owners during critical transitions.
Here are some of the key benefits:
Smooth Ownership Transitions
One of the primary advantages of a buy/sell agreement is that it ensures a smooth transition of ownership in the event of an owner’s death, disability, or retirement.
Without an agreement in place, the process of transferring ownership can become chaotic, leading to disputes among partners, family members, or other stakeholders. A buy/sell agreement establishes clear terms for how ownership will be transferred, minimizing conflict and helping your business continue operating smoothly during periods of change.
Business Continuity
A buy/sell agreement plays a crucial role in maintaining business continuity.
In the absence of a plan, unexpected events like the sudden death of a business owner could destabilize the company—a worst case scenario. The agreement ensures that the business can continue running without disruption by pre-determining how ownership interests are handled and providing the financial means for the buyout through funding mechanisms like life insurance.
This continuity helps protect employees, clients, and the future of the business.
Establishing Fair Market Value
One often overlooked benefit of an effective buy/sell agreement is that it helps establish the fair market value of the business. This is essential for ensuring that a departing owner’s shares are purchased at a fair price, avoiding disagreements over valuation.
The agreement can include specific methods for determining value, such as an agreed-upon formula or independent appraisal, giving all parties peace of mind that they will receive (or pay) a fair amount when the time comes.
Protecting Heirs and Family Members
In cases where an owner passes away, a buy/sell agreement can prevent family members or heirs from becoming unwanted business partners.
Instead of the ownership transferring to the family, the agreement ensures the business or the remaining partners buy out the shares, providing heirs with compensation while keeping the business in the hands of those who are actively involved.
Overall, a buy/sell agreement provides a layer of protection and certainty, helping to preserve the longevity and stability of your business.
Where Does Life Insurance Come In?
While a buy/sell agreement outlines how ownership of a business will be transferred, the actual funding for the buyout is a critical piece of the puzzle. This is where life insurance comes in.
Life insurance is often the most effective way to ensure that there are adequate funds available when a buyout is triggered by the death of an owner.
The most common types of life insurance used to fund buy/sell agreements are term life insurance and permanent life insurance:
Term Life Insurance is a cost-effective option, especially for businesses looking to cover a set period, such as until the owners retire. Term policies provide coverage for a specific term (e.g., 10, 20, or 30 years) and are typically cheaper than permanent policies.
While more expensive, permanent life insurance policies, such as whole life insurance, offer lifelong coverage and build cash value over time. The cash value can be used by the business to fund a buyout in the event of a retirement, disability, or another trigger besides death.
You may also have the option to fund your buy/sell agreement with key employee insurance. Also called key person insurance, this type of policy gives businesses a bit more flexibility when it comes to replacing someone vital to the company. In addition to purchasing the deceased person’s ownership shares, you can also use key employee benefits to fund your operations while you look for an adequate replacement.
Choosing the right type of life insurance for your buy/sell agreement depends on the specifics of your business and the agreement itself. An insurance professional can help tailor the right policy to fit your needs and ensure your buy/sell agreement is properly funded.
Protect Your Business with a Buy/Sell Agreement
A buy/sell agreement is more than just a safety net for your business—it’s a vital tool for ensuring smooth transitions, protecting your company’s future, and securing fair compensation for all parties involved.
Whether you’re in a partnership, own a small business, or are part of a larger corporation, having a buy/sell agreement funded by life insurance can make all the difference when the unexpected happens.
Don’t wait until it’s too late to protect your business. At Darr Schackow Insurance, we specialize in helping business owners like you secure the right life insurance policies to fund their buy/sell agreements. Our team is here to guide you through every step, ensuring that your agreement is fully funded and your business is protected.
Contact Darr Schackow Insurance today to get a quote and safeguard your business with a well-structured buy/sell agreement.