In Defense of the Buy-Sell Agreement-Part 2

In a previous post, we discussed the reasons why a business should consider key person insurance and possibly fund a buy-sell agreement. In this segment we are going to consider more complex applications for this increasingly critical business protection, as well as the type of life insurance that might be used.

For those new to this game, a Buy-Sell Agreement is simply an agreement among the owners of a business or the stockholders of a closed corporation to purchase, or to have the business or corporation purchase, the interest or shares of any withdrawing or deceased owner or stockholder.

Key Person Insurance is a life or disability insurance policy taken out by a business to compensate that business for financial losses that would arise from the death or extended incapacity of the member of the business specified on the policy. The company owns the policy, pays the policy premiums, and is typically the beneficiary, partly or in whole. Those premiums are NOT tax deductible, but the death benefit is generally paid tax free. The key employee is the insured and often provided beneficial interest.

Where the scenario gets interesting, is how the company structures the beneficial interest and what terms are demanded to obtain that benefit. This is the executive's incentive and also the tool used by the employer to keep top talent.

The additional variable is how to properly fund the policy to allow the cash value to reach the desired level for payout. This is where the advice of a competent insurance advisory firm like Fifth Street Financial Group becomes exponentially important.

Here are a few examples where this type business insurance would apply:

1. Retain Executive-By designating the key employee's family as beneficiary, but putting restrictions on the executive such as length of employment, the company can increase probability the employee will stay at the firm. Type of policy used-Permanent Life Insurance, such as a Universal Life or Term Life.
2. Pay Executive On Death-If key executive permanently checks out, the family and/or company received the death benefit from life policy. Classic use of corporate life insurance. Type of policy used-Term or Permanent Life Insurance depending on need and budget.
3. Pay Company if Executive Leaves
   If key executive leaves company prematurely, cash value is taken out of policy (and policy cancelled) and used to offset financial loss suffered by firm. Type of policy used-Permanent Life Insurance.

Take Your Business Attorney to Lunch

Having a good relationship with a competent business attorney is important when considering a Buy Sell Agreement. This important advisor creates the legal instrument that will dictate terms when company ownership transfers from one entity to the next.   This might involve partnership interests, or family assets from patriarch to the children.  There are also additional applications for the BSA that don’t involve death, such as an equity partner leaving the firm or the transfer of ownership in sale or merger.  A buy-sell agreement funded with a permanent life insurance policy gives a multitude of options to business owners. Never made the time to execute and fund a BSA? Your balance sheet is going to take a substantial hit, not to mention the cost of negotiating an agreement after the fact.

According to Trevor Zink, managing partner of Omni Law Group, located in Campbell, CA:

Attorneys like drafting buy-sell agreements because it helps their clients avoid the pitfalls that often come from failing to put one in place. However, attorneys love getting new clients who failed to execute the buy-sell agreement, because this inevitably leads to a lengthy, expensive, and fun (for the attorneys) litigation. I say this tongue-in-cheek, but the reality is that the old adage ‘an ounce of prevention is worth a pound of cure’ is certainly true in the buy-sell agreement world.

Let’s recap couple of reasons why you should spend pennies to save dollars by mitigating key executive risk with corporate owned life insurance.

• Avoid Draining Company Cash- Ex-partner's ownership shares need to be paid or you will acquire an unwelcome new partner!
• Increase Company Valuation-Considered an asset on the balance statement.
• Provide Less Risk for Investors & Lenders- By considering investor risk firstly, your chance of getting needed funding increases. You are providing a financial safety net.

In the end, this is all about mitigating business risk for minimal skin in the game. You have car insurance don’t you? The same principle applies to your business. Offset that risk with a well planned Buy-Sell Agreement.

The opinions expressed here are the blogger's and not necessarily those of the local editor's or anyone affiliated with Patch.