Hi, it’s nice to meet you. My name is Shocked (insert handshake). It’s 2016 and we just agreed to do business the “good ‘ol boy” way- with a handshake. Does this still happen? Brace yourself, partner. It does.
Handshakes are so 1980: Why you Need a Buy Sell Agreement
Written by Shelly Alvarez
By now I’ve talked your ear off on the importance of insuring your Venture Capital funds, whether it be you who’s lending the money, or you, the owner of a start-up, who received the funding. You SHOULD be looking into a life insurance policy to insure this money, as well as Disability Insurance protection and Employee Benefits.
Then there’s the Buy Sell Agreement. “Well,” you say, “my partner and I are brothers or long-time friends and know how to work together just fine.” “Cool,” I say, “don’t call me when your partner gets a little taste of the business growth and starts to love his newfound wealth, and comes up with a way to take you to the cleaners by screwing your family out of their fair share when you die.” Sorry for the somber news, but it happens every day, all with a 1980’s-style handshake and a smile.
So many start-ups are guilty of one big thing: lack of knowledge. It’s so exciting to start a business and see it grow (hey, it beats the alternative, right?). If you are on your own and have no partners, you’re excused from a Buy Sell Agreement (but you still need other coverage, so check out my last blog, Start-ups: 5 Quick Ways to Close your Business Doors). But if you have a partner(s), it’s time to listen up. You need a Buy Sell Agreement, like, yesterday.
A Buy Sell Agreement is drawn up by your business Attorney. It is meant to protect the owners and partners of a business, should they die while still being affiliated with the company. It basically allows the family members of the owner/partner to sell the value of your business interest back to the company, in exchange for the agreed upon price stated in the BSA.
How can I fund this?
There are many ways to fund a Buy Sell Agreement, but the easiest and most common is with life insurance. A Buy Sell Agreement has many options and ways to structure it. Most typically, the company or each owner/partner purchases a life insurance policy on the lives of each other. If you kick the bucket during the agreed upon contractual term, the life insurance proceeds go to your family (beneficiary) in exchange for your interest in the business. The family is ecstatic with that big, fat, tax-free check, and you are, well, dead. But the business can continue to run as usual this way (consult your tax advisor to ensure the benefits are tax-free in your State).
Another method of funding a Buy Sell Agreement with life insurance is an Entity Purchase. The business buys a policy on each owner, and also pays for it. In this scenario, the business would own the policy and be its beneficiary.
There’s a Cross Purchase Buy Sell Agreement option, too, where each owner would buy a life insurance policy on each of the other owners (and if there are a lot, get ready to spend some dough because you’ll purchase a policy for EACH owner). The owner who purchases the policy would be the owner of that particular policy on the other owner, and would be the named beneficiary (but who would be the owner of the policy’s owner’s owner? Sorry, just a little insurance joke). In return, they pay the annual premiums for the policy.
How much should the policy be valued at?
There are many factors when determining the value of an owner/partner as it relates to a Buy-Sell Agreement. Obviously, when you are a start-up the value of the business may be relatively small compared to what it might be in several years. The life insurance policy value should be your valued interest in the business (and I know you’ve had your business appraised since you were a candidate for venture capital financing).
If the business’ value skyrockets and you outgrow the death benefit, your attorney can add to the agreement options where the coverage can be increased at a later date (Gold Star for you!) based on tenure or performance. In addition, with your current beer budget you may not be able to afford the entire business value of a co-owner right now, so you may purchase a smaller policy with options to buy more at a later date.
Something else to fathom (although it’s just about unimaginable): if your policy benefit exceeds your business value at your death (ouch), your Buy Sell will state where the excess funds should go (back into the business in most cases). This will be up to the business and your attorney to decide, however.
What are the drawbacks?
A big drawback is the fact that maybe you aren’t as healthy as you thought you were, and cannot qualify for life insurance. There are underwriting requirements that must be met in order to be a life insurance candidate. Keep in mind that your medical history and age play a factor in your final premium, so another owner who is the same age as you, but who is in better health, could have a lower premium. Your Buy Sell Agreement may need to specify what to do with the difference in premium if this happens. We are able to help many people with severe medical conditions get the coverage they need, so never assume you can’t get covered because you have an illness.
There may be some tax implications for C-Corporations, but your tax advisor can help with that. Also, annual insurance premiums paid by the business are usually post-tax.
How do I get started?
Um, this would be the time to sit you down and have that “common sense” talk. Hiring an attorney would be a good start! Then, once your Buy Sell is in place and ready to go, contact us and we’ll walk you through the rest.