Funding a buy-sell agreement means establishing how a purchaser will pay for an owner’s interest when death, disability, retirement, or another event triggers a buyout. Life insurance can provide money for a purchase after an owner dies, while disability insurance, cash reserves, financing, or installment payments can address other events that lead to a transfer. The company may also obtain key person insurance to remain financially stable after losing an important owner. Your buy-sell agreement and funding plan must work together so that the purchaser can complete the ownership transfer without unnecessary cash-flow or operational problems.
The attorneys at BrewerLong can help you create a buy-sell agreement and plan the funding you need to complete it. We have helped business owners throughout Central Florida plan for every stage of the business lifecycle, including formation, growth, ownership transitions, and succession, since our 2008 founding. At BrewerLong, we take the time to understand your company, your relationships with your co-owners, and your long-term goals so that we can customize your plans.
How Does a Buy-Sell Agreement Work?
A buy-sell agreement identifies the events that may trigger a purchase, who may or must buy the interest, and how the parties will determine the price. Funding a buy-sell agreement begins with what the buy-sell agreement says. Every buy-sell agreement should answer several questions.
What Events Can Trigger a Buyout?
A buy-sell agreement typically identifies events that trigger a buyout, such as:
- Death,
- Long-term disability,
- Retirement,
- Voluntary departure,
- Termination of employment,
- Divorce,
- Bankruptcy, and
- Loss of a required professional license.
You may select different transfer processes based on the type of event. Depending on the circumstances, an event may:
- Require a sale and purchase,
- Give the company or remaining owners an option to purchase, or
- Give the departing owner or estate the right to require a purchase.
Different events may also require different sources of funding.
Who Purchases the Ownership Interest?
Your agreement must identify who is permitted or required to purchase the departing owner’s interest. You may have individual owners or the business purchase the interest.
How Will You Establish the Purchase Price?
Buy-sell agreements typically select a method for determining the value of the business and business interests. Your agreement may establish the price through a:
- Fixed value,
- Formula, or
- Appraisal.
The agreement should also establish the valuation date and explain how the price reflects the departing owner’s percentage interest. Those terms create a starting point for calculating the amount the purchaser may need.
How Do You Fund a Buy-Sell Agreement?
After establishing the terms of your buy-sell agreement, you need to identify how the designated purchaser will pay the purchase price. Businesses often use a combination of:
- Insurance,
- Cash,
- Financing,
- Purchaser contributions, and
- Installment payments.
A buy-sell agreement creates or governs a purchase obligation, but it does not create the cash needed to perform that obligation. If the purchaser lacks sufficient funds, the company may have to divert money from payroll, debt payments, inventory, or planned growth. The remaining owners may have to contribute personal funds or assume unexpected debt.
Inadequate funding can also delay the intended ownership transition. A deceased owner’s estate or family may hold the interest while the parties resolve payment, which can create uncertainty over voting rights, distributions, access to information, and important business decisions.
What Is Key Person Insurance?
Key person insurance is coverage a company purchases on an owner, executive, or employee whose death or disability could cause the company significant financial loss. The company typically owns the policy, pays the premiums, and receives the benefits after a covered event. Depending on the risk the company wants to address, it may obtain key person life insurance, key person disability insurance, or both.
The company can use key person insurance benefits to:
- Replace lost revenue,
- Preserve cash flow,
- Meet debt obligations,
- Recruit a successor, or
- Transfer the key person’s responsibilities.
As part of a buy-sell plan, this coverage complements the funding designated for the ownership purchase. Buyout coverage provides money to acquire the affected owner’s interest, while key person coverage provides money to help the company continue operating during the transition.
How Can You Fund a Buyout Triggered by Death?
An owner’s death can create two financial needs to address. The company or remaining owners may need money to purchase the deceased owner’s interest. At the same time, the company may need money to replace the owner’s contributions and remain financially stable. Life insurance can fund the ownership purchase, while key person life insurance can support the company through the transition.
To fund a death buyout, the company or remaining owners purchase life insurance covering each participating owner. When an insured owner dies, the insurer pays the death benefit to the policy beneficiary. The beneficiary uses the proceeds to purchase the deceased owner’s interest under the buy-sell agreement.
When an important owner dies, the company may lose leadership, specialized knowledge, and client relationships at the same time the buy-sell agreement requires an ownership transfer. Key person life insurance gives the company money to address those operational effects. The company can use the death benefit to stabilize cash flow, recruit and train a successor, repay debt, or cover expenses while other owners and employees assume the deceased owner’s responsibilities.
How Can You Fund a Buyout Triggered by Disability?
An owner’s disability can create financial needs that parallel those created by death. The company or the remaining owners may need to purchase the disabled owner’s interest and seek financial support because the owner can no longer work. Disability buyout insurance can fund the ownership purchase, while key person disability insurance can support company operations.
Disability buyout insurance can provide funds if an owner meets the policy’s definition of disability and remains disabled through its waiting period. Depending on the policy, the insurer may pay a lump sum, installments, or both after the insured owner becomes disabled. The policy owner or other designated recipient can use those benefits to complete the buyout.
Key person disability insurance can also cover the company’s losses when a key owner becomes unable to work. Depending on the coverage, the company may use the benefits to replace lost productivity, preserve cash flow, hire temporary or permanent leadership, and cover continuing financial obligations.
How Can You Fund a Buyout Triggered by Other Events?
Life and disability insurance provide benefits after defined insured events. They generally do not provide buyout funds when an owner retires, leaves voluntarily, loses employment, divorces, files for bankruptcy, or becomes subject to another transfer provision. You typically use cash reserves, purchaser contributions, financing, installment payments, or a combination of those sources for other buyouts.
How Can You Structure Insurance Funding?
After determining what coverage you need, you must identify who will own each policy, pay its premiums, receive its benefits, and complete the purchase. Businesses often structure funding as either an entity purchase or a cross purchase. The purchaser that you select in your buy-sell agreement generally determines whether the parties use an entity-purchase or cross-purchase structure. Policy ownership and payment designations then carry out that choice.
Under an entity-purchase structure, the company owns a policy covering each participating owner, pays the premiums, receives the applicable benefits, and purchases the affected owner’s interest after a covered event. When the company redeems that interest, the remaining owners hold larger proportional interests in the company.
Under a cross-purchase structure, the participating owners purchase policies covering one another. When an insured event occurs, the purchasing owners receive the benefits and purchase the affected owner’s interest directly.
How Much Insurance and Other Funding Do You Need?
Once you identify the triggering events, purchasers, and funding methods, you can calculate how much money the plan requires. You should estimate the buyout obligation separately from the company’s key person needs, then address any difference between the available funds and the amount ultimately required.
How Do You Estimate a Buyout Obligation?
Use the agreement’s valuation method to estimate the purchase price for each owner’s interest. Then compare that amount with the applicable insurance benefit, cash reserves, and available financing.
Company value, debt, and ownership percentages change over time. Periodic valuations allow you to adjust coverage and other funding before a triggering event creates an unexpected shortfall.
How Do You Estimate the Company’s Key Person Needs?
Estimate how losing an owner might affect revenue, client relationships, productivity, debt obligations, and replacement costs. Also consider how long the company may need to transfer the owner’s knowledge and responsibilities.
Keeping that calculation separate from the buyout price reveals how much coverage the company needs for operations in addition to the amount required for the ownership purchase.
How Do You Address a Funding Shortfall or Excess?
Your agreement should explain how the purchaser will pay any amount exceeding the available insurance benefits. The purchaser might use reserves, obtain financing, make additional contributions, or pay the balance in installments.
The plan should also address benefits exceeding the final purchase price. The proper treatment may depend on who owns the policy, who receives its benefits, and whether the policy also serves a key person purpose.
How Do You Coordinate Your Funding and Tax Plans?
The insurance structure, buyout terms, and tax plan must support the same transaction. Life insurance benefits are generally excluded from the beneficiary’s federal gross income, but policy transfers, employer-owned coverage, and the selected purchase structure can affect that result. Entity-purchase and cross-purchase arrangements can also produce different tax-basis and estate-valuation consequences.
Your attorney can coordinate the agreement’s purchase and payment terms with the policies you select, and your tax advisor can evaluate notice, consent, reporting, basis, and estate-tax issues before you finalize or change the arrangement.
When Should You Review a Florida Buy-Sell Agreement?
Review Florida buy-sell agreements and funding plans periodically and after changes in company value, ownership, debt, cash flow, owner health, or business structure. Confirm that coverage remains active, the policy owner and beneficiary still match the agreement, and the benefit still corresponds to the likely purchase price.
You should also update the agreement if its triggering events, valuation procedures, purchaser, or payment terms no longer reflect your intended transition. A policy lapse or outdated benefit does not eliminate the purchase obligation established by the agreement.
Coordinate Your Buy-Sell Agreement and Funding Plan with BrewerLong
A buy-sell agreement can provide an orderly path for transferring ownership if the designated purchaser is able to complete the transaction when the time comes. BrewerLong’s Central Florida business attorneys can help you establish triggering events, valuation procedures, purchase obligations, and payment terms to create an effective buy-sell agreement. We can also help you evaluate entity-purchase and cross-purchase arrangements and coordinate your agreement with your insurance and tax professionals.
Contact us to create or review a buy-sell agreement and develop a practical funding plan that supports both the ownership transition and the company’s continued operations.
Legal References Used to Inform This Page
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