Business owners are builders. They spend their lives building firms to provide goods and services to their clients, and those firms provide them with a living. But nothing can tear down that lifetime of work faster than the death of a business owner or the death of a business partner. Often, much of the value of a business dies with the owner.
Small-business owners face two major succession questions:
First, can the business heirs keep the company afloat when the owner dies, or at least avoid surrendering it at a “fire sale” price? The executor of a deceased business owner’s estate can elect to continue the company, but must find someone willing to run it. That may not be easy. Some heirs or business partners may want to keep things going, others may want to cash out. This discord can potentially sink a firm, because if the business continues, any partners wanting out will want to be fairly compensated. If sufficient cash isn’t on hand to do that, liquidation may be the only option.
Selling the business means finding a buyer. Any potential buyer will be negotiating with an advantage, for the business will become less valuable with each passing day following the owner’s death.
Now to the second major succession question: How can an owner keep employees confident that the business — and their jobs — will continue after he or she is gone? Surviving business partners may need to be reassured as well. If one partner dies, the remaining partners may find themselves in business with the deceased partner’s heirs, who may have different goals for the company. If the heirs want to sell their inherited ownership interest, is there enough cash on hand to buy it?
These questions can throw the value and continuation of a business into doubt. If left unanswered, they could make creditors more likely to call in loans, and make retaining key employees harder.
Cross-purchase buy-sell agreements are designed to answer these questions. Often funded by life insurance, these agreements are essentially deals struck between owners, partners or key employees of a business, permitting the sale of their ownership share to another person.
How do they work? In the classic cross-purchase buyout agreement, each business partner takes out a life insurance policy on the other partners within the company, naming himself or herself as the beneficiary of those policies. If one partner passes away, then one or more beneficiaries can use the life insurance proceeds to buy the deceased partner’s ownership interest. This way, partners or key persons can continue to work and operate the business seamlessly and the deceased partner’s heirs receive a fair, agreed-upon price for the ownership interest.
Thanks to the buy-sell agreement, both heirs and partners know that the business is positioned to continue. In addition, greater productivity and loyalty may be seen from any key employees made part of the agreement who see ownership in their future.
The sale can happen rather quickly; estate issues can be settled more expediently. Heirs will get a fair, pre-determined price for the ownership interest and won’t be selling under duress.
These agreements do have some disadvantages. Participants have to trust and verify that each partner keeps his or her insurance policy in force. This isn’t as simple as making sure premiums are paid. Usually the policies are owned personally, not by the firm. If a partner suffers a bankruptcy, federal or state exemptions may not protect all of its cash value from creditors. Sometimes a participant will mistakenly buy an insurance policy on her or his own life and make the other participants beneficiaries. Under those conditions, the insurance payout resulting from his or her death will likely be taxed.
As the number of partners involved in a buy-sell agreement increases, the number of policies grows exponentially, as does the cost of the agreement. Two partners? Two policies. Three partners? Six policies. (When three partners are involved in a cross-purchase buyout agreement, Partner A needs to buy coverage for Partner B and Partner C, etc.) Speaking of cost, an older or less healthy partner will pay much more for the agreement than a younger, healthier partner, as life insurance is a necessary component.
Before you make a decision about how you’ll protect the future of your business, it may be wise to speak to a qualified financial advisor who can help you research this option as well as others.
Mark Lund is the author of The Effective Investor and provides investment and retirement planning for individuals and 401(k) consulting for small businesses through Stonecreek Wealth Advisors Inc. in Utah.