BY PHIL SHETSEN
In this three-part series, I’m taking a look at preparing for the future of your business, specifically succession planning. Whether you’ve been mulling it over for months or this is the first time you’re hearing about it, this is an essential part of your business. We’ll cover critical aspects of succession planning to ensure your business remains operational during an ownership change. In this first part, we will explore the importance of buy-sell agreements, their role in safeguarding your business, and how to effectively fund these agreements. Let’s get into it.
Why Does My Business Need a Succession Plan?
It’s a great question, but the real question you should be asking is, ‘When do I want to retire?’ A succession plan is vital for when you’re aiming for retirement, and it’s also essential for unplanned events, such as disability or an unexpected death. Without a well-structured succession plan, you’re risking financial instability, tension among stakeholders, and even a total collapse of the business.
The Roles of the Passive Owner and Active Owner
One of the most critical aspects of succession planning is addressing the roles of active versus passive owners. Active owners are deeply involved in the day-to-day operations and decision-making processes of the business. Passive owners, on the other hand, may hold equity but are not actively engaged in the business’s management. A buy-sell agreement ensures a seamless transfer of ownership, allowing the business to continue operating smoothly regardless of who is at the helm. Without clarity in the roles of active and passive owners, businesses face potential internal conflicts.
The Importance of Business Valuation
A legitimate valuation is central to any buy-sell agreement. It ensures that the business’ worth is objectively determined and acceptable to all parties involved before any transfer of power occurs. Proper valuation methods, such as market-based, income-based, or asset-based approaches, provide transparency and fairness, reducing the risk of disputes during ownership transitions. You should always periodically review your valuation. Avoid outdated valuations, as they can lead to disagreements or inequitable outcomes if triggered by a death, disability, or other buyout event.
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that governs the transfer of ownership if a triggering event, like the ones we’ve been talking about, occurs. This agreement basically makes sure that when an ownership transition happens, there’s no funny business.
Approaches to Transfer of Shares
When ownership changes, so do the ownership of a company’s shares. Buy-sell agreements can be structured in various ways to handle the redemption of shares, including:
1. Entity redemption: The business itself buys back the shares of the departing or deceased owner.
2. Cross-purchase: Remaining owners individually purchase the shares of the departing or deceased owner.
3. Hybrid approach: Combines elements of both entity redemption and cross-purchase methods, allowing flexibility based on the situation.
Funding a Buy-Sell Agreement
A buy-sell agreement is only as strong as its funding, so how do you go about doing such a thing? Some common methods include:
1. Loans: The business or remaining owners take a loan to buy out the departing owner’s shares.
2. Sinking fund: The business sets aside funds over time to prepare for a buyout.
3. Installment sale: Payments are made to the departing owner or their estate over time.
4. Life insurance: Policies are taken out to fund buyouts in the event of death or disability.
The Recommended Strategies
It can be an uncomfortable topic to discuss, but life insurance is often the most reliable and cost-effective way to fund a buy-sell agreement. There are two ways to go about this:
❱ Entity stock redemption: The business owns the life insurance policy on each owner. When an owner dies, the business uses the policy’s proceeds to buy back their shares.
❱ Cross-purchase: Each owner holds life insurance policies on the others. When an owner dies, the remaining owners use the proceeds to buy out the decedent’s shares.
Addressing Disability in Succession Planning
While much attention is given to what happens when an owner passes away, planning for disability is equally critical. A disabled owner may be unable to fulfill their duties but could still hold equity in the business. A buy-sell agreement outlines how to handle this situation.
Without these guardrails in place, your business may face financial uncertainty and internal disputes that frankly can get ugly. Disability provisions should be paired with funding mechanisms to ensure your business can afford the transition without undue financial strain.
Connelly v. United States
To really hammer home this point, I want to cite a famous (or infamous) case that outlines the importance of many of the things I’ve spoken about so far.
In the case of Connelly v. United States, the court ruled that life insurance proceeds funding a buy-sell agreement were not fully exempt from estate tax if the deceased owner had an ownership interest in the policy.
As a family-run enterprise where the business owners were related, this ruling underscores the need for meticulous planning to avoid unintended tax liabilities. Unrelated owners also need to ensure their agreements clearly delineate ownership and beneficiary arrangements to minimize disputes like these. Consider working with an experienced advisor to help navigate these unnecessary, and potentially costly, situations.
Conclusion
We covered a lot in this first part, but there is much more to discuss. For now, consider a buy-sell agreement as an indispensable component of your business succession plan. By addressing critical issues such as valuation, funding, and ownership roles, these agreements provide stability and clarity during turbulent times.
The next articles in this series will delve into additional pitfalls of succession planning, offering practical solutions to safeguard your business’ future. See you next time! [CD0218]
Phil Shetsen is the president of Bona Vita Benefits. He can be reached at phil.shetsen@prudential.com.