As stated earlier, businesses are easy to start, hard to get out. With partnerships, all owners need clauses in the partnership agreement to deal with divorces, death and incapacitation. Corporations, partnerships and sole proprietors might also want to effect ownership transfer or buyout. Easy, right. Yes, easy from an administrative perspective. For example, a divorce clause is straightforward. In the event a partner or shareholder get divorced, the business has the right to purchase the ownership interest of the divorcing owner. Yup, easy.
But wait. What about the money? Let’s say the corporation is worth $1.0 million, but only has $200,000 in cash. How does the corporation buy out a 50% owner with $200,000 when his or her share is worth $500,000? Enter the Buy Sell Agreement funded by life insurance and drafted by an attorney, and reviewed by your tax and accounting consultants.
The first requirement is to establish a price. This could be a fixed amount regardless of company health, or it could be a formula such as the 3x net income plus book value. Or to help avoid fighting and heartburn, the agreement could name a third-party business valuation firm or arbitrator. It is a balance between what is fair and what is easy to administer.
Next, the owners or partners would purchase a cash value life insurance policy on each of the other owners or partners. So, if there are three owners, each owner would buy two life insurance policies for a total of six policies. If an owner dies the remaining owners will use the death benefit to pay for the deceased’s ownership interests. If the owner departs either through divorce or incapacitation or some other contractual obligation such as removal for cause, the remaining owners will use the cash surrender of the life insurance policy to purchase the departing owner’s interest.
Many people are reading this book because they are considering getting into business, and perhaps the Buy Sell Agreement is just silly to even think about. But, as the Watson CPA Group has witnessed numerous times before, small businesses have a unique way of becoming big businesses, and at some point exit strategies must be considered.
Having said that, Buy Sell Agreements are unnecessary in two cases- first, when the company has no value. Second, when the remaining owners or partners could very easily shutdown the old company and start a new one without the deceased or departed owner.
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