Many business owners may be good at running their companies, but the majority of them are failing to address essential long-term planning that is critical to sustaining their businesses.
The one area that the majority of business owners often neglect is planning for business continuity if they die or become disabled, according to the “MassMutual Business Owner Perspectives Study.”
While the question of your death or disablement is not one that’s fun to ponder, it makes good sense for business owners to put plans in place in case the worst happens. This is especially important now amid the COVID-19 pandemic which has put the issue front and center for many business owners who want to ensure their company can survive should they become incapacitated or pass on.
One of the main ways to ensure your business’s survival is to have a buy-sell agreement, which would prompt the sale of your company in the event that you are unable to run it any longer.
Business owners in the survey identified these concerns:
- The effect on the business of the death or disability of the owner or key employee.
- Protecting the business from disability and death of an owner or key employee had the second and third highest levels of importance (44% versus 42%, respectively). However, these two pillars were not the very top of respondents’ minds, with 55% saying they rarely or never think about the effect of disability and 59% saying they rarely or never think about the effect of death.
- Of those with a buy-sell agreement in place, just over half said it was funded with life insurance, but only 5% said it was funded with disability buy-out insurance. The rest were either funded with cash flow from the business or not funded at all.
What’s a buy-sell agreement?
A buy-sell agreement, also known as a buyout agreement, is a legally binding agreement between co-owners of a business that governs the situation if a co-owner dies or is otherwise forced to leave the business, or chooses to leave the business. If the business has just one owner, then the agreement should specify who would be buying the company and continue its operation.
A buy-sell agreement should be designed to protect the business from the five D’s – death, disability, divorce, departure, and disqualification.
When properly executed, a buy-sell agreement can help ensure the continuity of the business when ownership needs to change hands for any reason. It is a legally binding agreement that requires one party to sell and another party to buy ownership interest in a business when a triggering event occurs, such as the death, disability, or retirement of an owner.
This agreement structures the method and manner in which the business will continue in the event of the owner’s death.
In a 2003 article for Franchising World magazine, Patrick Olearcek explains: “The proprietor and one or more key employees [or partners] enter into an agreement which provides that the proprietor’s estate will sell the business to the employee at death.”
By agreeing to buy the company, the key partner, employee, or associate relieves the owner’s family of the responsibility and instead provides them with a lump-sum payment. A key employee, as opposed to the owner’s family, is in a much better position to continue the business operations properly.
Funding the agreement
The majority of buy-sell agreements are funded with life insurance. In the case of a sole proprietorship, a policy covering the life of the owner is typically bought and paid for by the key employee who has agreed to purchase the business.
The employee is also the beneficiary of the policy, which has a death benefit equal to the pre-determined purchase price of the business. Upon the death of the owner, the employee would receive the proceeds of the life insurance policy, then transfer that money to the owner’s heirs in exchange for all interest in and assets of the business.