As an entrepreneur, you know that starting a business is challenging. What you may not have considered is how difficult continuing that business can become, especially if one of your co-owners retires, gets divorced, or suddenly becomes disabled or dies.
A business may face significant cash flow problems and internal strife should an owner unexpectedly leave. You might, for example, need to quickly raise money to purchase a retiring owner’s interests or, in the case of an owner’s divorce, disability or death, you could suddenly find yourself in business with his or her family.
Because you have the best selection of options for creating a desired exit strategy before you or another owner leaves, now is the best time to begin planning.
Planning for Contingencies
A well-crafted buy-sell agreement helps ensure the smooth transition of business interests. It should clearly define what happens if you or another owner retires, gets divorced or becomes disabled or dies.
Several types of buy-sell agreements are available to accommodate variations among businesses, including organizational structure, number of owners, whether the owners are related and who the purchasers will be.
Selecting an Agreement
Three common methods for transferring business interests include a cross purchase agreement, an entity purchase agreement and a wait-and-see agreement. Each offers unique advantages along with considerations to keep in mind when selecting an agreement.
With a cross purchase agreement, the remaining owners purchase the departing owner’s interest. Remaining owners obtain an increased basis that can result in tax savings if the interest is later sold.
With an entity purchase agreement, the business purchases the departing owner’s interest. Because the funding is provided through the business rather than the owners, as in a cross purchase, the overall process is made simpler, particularly if there are three or more owners.
And with a wait-and-see purchase agreement, there is a sequence through which an interest is made available for purchase.
In a typical wait-and-see agreement, the business has a first option to buy all or a portion of a departing owner’s interest. Second, after the business has had the opportunity to buy, the remaining owners have the option to buy any remaining interest. Finally, any interest not purchased by the remaining owners must then be purchased by the business.
Because this approach is a combination of a cross purchase and entity purchase, the advantages of both are available, and the business and the owners can decide which option is optimal when a buyout is triggered.
Flexibility is Central
All types of agreements offer flexibility in how the business is valued and how interests can be transferred. An agreement, for example, can set a fixed purchase price, define a formula or call for an appraisal to determine fair market value. Similarly, the agreement can stipulate that the payout must be made in a lump sum or in installments.
An agreement can also address divorce. Qualification for ownership, for example, could exclude former spouses of owners. It can provide the business or the owners with an option to buy a former spouse’s interest. It could also stipulate the creation and adequate funding of a contingency fund that would provide the assets needed to purchase the interest of the divorced owner’s former spouse.
Another way for owners to protect their interests is through a pre- or post-nuptial agreement, which should be coordinated with the buy-sell agreement. Pre- and post-nuptial agreements can specify whether the owner’s spouse will have any right to the business on divorce and, if so, the manner in which the business will be valued and divided.
Regardless of the terms, however, the ultimate goal of any agreement is to avoid conflict and confusion by correctly transferring business interests in a timely manner to the desired people with the least possible conflict, expense and delay.
Where’s the Money?
No matter how well it’s written, a buy-sell agreement is only as good as the funding, which makes the actual purchase of a departing owner’s interest possible.
Options include using existing assets, borrowing the money, creating a cash reserve fund, making installment payments and purchasing insurance. The key is to select the combination that meets evolving business needs and provides the required certainty.
Of these options, disability and life insurance are two of the more effective choices for a number of reasons. Both can be more cost effective and easier to administer. Each can protect working capital and help provide the correct amount of financing at exactly the time it’s needed.
Life insurance helps assure funding is available to purchase an interest if an owner dies, while disability insurance helps assure funding is available if an owner becomes totally disabled.
A totally disabled owner may become more concerned with his or her family and personal well-being and less concerned with his or her participation in the business. Buying out the disabled owner’s interest often becomes the logical choice for the remaining owners.
Benefits paid from the policies are generally income tax free, and the cash value of permanent life insurance grows tax deferred and is available to help meet other business needs. Life insurance can also be used to equalize property distribution in the event of divorce.
How the insurance is structured, meaning who will be the applicant, owner, insured, beneficiary and payer, is determined by the type of agreement selected.
Protecting You, Protecting Your Business
You and your partners are working hard to build your business. A properly drafted and funded buy-sell agreement can help protect that vital asset should the unexpected happen. Think of it as a formal exit strategy that can give you options that might not otherwise be available after the retirement, divorce, disability or death of an owner.
If you haven’t already, begin working with legal, accounting and financial professionals who are experienced in the field of business valuation and succession planning. The right team of advisors can help you access your readiness and create an exit strategy so that, when the time comes, you will be well positioned to transition your business on your terms.
Article prepared by Northwestern Mutual with the cooperation of Andrew Ekberg. Andrew Ekberg is a Financial Advisor with Northwestern Mutual, the marketing name for The Northwestern Mutual Life Insurance Company (NM) (life and disability insurance, annuities), Milwaukee, Wisconsin, and its subsidiaries. Andrew Ekberg is an agent of NM based in Lakewood, CO. To contact Andrew Ekberg, please call (303) 819-7269, email him at firstname.lastname@example.org or visit his Web site at andrewekberg.nm.com.