Buy-sell agreements are contracts behind business partners that spell out how a partner’s share in the company will be obtained by the remaining partners when the partner in question dies or otherwise departs.
But a buy-sell agreement doesn’t do much without a plan to fund it. Funding a buy-sell agreement involves securing the necessary money to facilitate the transition of ownership once a triggering event occurs. That triggering event could be the death, disability or retirement, for example, of one of the owners.
There are several common methods to fund a buy-sell agreement
Because there’s no way to predict what the future may bring, it’s often best to consider more than one method of funding. Some common methods companies use include:
- Sinking funds: Some businesses set aside cash reserves from their profits specifically for the purpose of funding buy-sell agreements. This approach requires disciplined savings over time, however, to accumulate the necessary funds.
- Cash out-of-pocket: In some cases, the purchasing owner(s) choose to fund the buy-sell agreement out of their personal savings or assets. This can be an option for smaller businesses or situations where the purchase price is relatively low (or the owners fairly affluent).
- Installment payments: The purchasing owner(s) sometimes agree to make installment payments to the departing owner until their obligation is met. This can be difficult, however, if the business hits a slump or has cash-flow problems.
- Borrowing: The purchasing owner(s) might secure a loan from a financial institution to fund the buy-sell agreement, using business assets as collateral.
- Life insurance: Business owners often purchase life insurance policies on each other. In the event of the owner’s death, the death benefit is used to fund the buyout to the deceased’s estate.
- Disability insurance: Similar to life insurance, disability insurance can be used to fund a buy-sell agreement in cases where an owner becomes disabled.
Businesses may even use a combination of these methods (and others) to fund a buy-sell agreement. For instance, they might use a mix of cash reserves, life insurance and loans to ensure adequate funding.
It’s difficult to understand the complexities of a buy-sell agreement, but appropriate legal guidance can help you to ensure that your company is as prepared as possible for the future.
