A buy/sell agreement is a legal document among partners that sets the terms for buying shares of the business when those shares become available. These agreements can, and should, be funded with life insurance. In the case of a partner’s death, the policy can provide the funds to buy the deceased partner’s share of the company.
Any business that has at least two owners should have a buy/sell agreement, which will include a current value of the business. As the business grows and becomes more profitable, a valuation of the business should be completed on a regular basis. Too often, however, this important step is overlooked. That, says Craig Berson, President and CEO of Berson-Sokol Agency Inc., can create significant problems for the remaining partners.
Smart Business spoke with Berson about the role of life insurance in buy/sell agreements, and the importance of periodically revisiting and updating these policies.
Why is life insurance important to a buy/sell agreement?
Upon the death of a business partner, a life insurance policy can provide funds to help cover the cost of buying out the deceased partner’s shares. Life insurance comes in two forms, Term and Permanent. Either can work, but permanent insurance has more value and flexibility.
Depending upon the structure of the company, there are a few strategies that can be used. One strategy is a cross purchase, in which each partner owns a policy on each of the other partner(s). Another strategy is an entity purchase, in which the business owns a policy on each partner for their value of the business. A qualified business attorney should be consulted when structuring the buy/sell agreement.
What issues can arise with life insurance-backed buy/sell agreements?
The most common issue is that the business increases in value and the value of the life insurance has remained static. Business owners often fail to review the value of their business and adjust their life insurance policy by buying additional coverage or increasing the coverage to reflect the new value. That could leave a sizeable gap in the funds available to cover the purchase of a partner’s shares.
Some insurance companies will offer to perform a business valuation that can be used to set the policy coverage, and often for free. However, it’s the owners’ responsibility to initiate that review, which should be done annually, or at least every few years.
Some business partners can encounter an issue with insurability. For instance, if one partner has significant health issues, that partner might not be able to get the best rate on life insurance, or worse, may not pass underwriting and not be issued a policy.
Who can help business partners with these arrangements?
A qualified broker can work with a lawyer and the business partners to structure a life insurance plan for a buy/sell arrangement. A qualified broker has access to many insurance companies and will be able to find a policy to cover the business partners at the best rate. Additionally, a broker can work with underwriters to get a policy issued for a partner with health issues.
Life insurance plays a major part in ensuring that a business continues with the desired ownership. Funding a well-crafted buy/sell agreement that is backed by the right life insurance policy will give the remaining partners the money to buy the deceased partner’s share of the business. Without the life insurance proceeds, the remaining partners may be forced to seek a loan from a bank, or partner with the deceased partner’s spouse or children. ●
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