When business partners create a company together, they have big hopes for the future. Unfortunately, things don’t always go as planned. Business failure isn’t the only potential problem, either. Sometimes, the business itself is performing well, but it’s the business owners that run into difficulties. Disability buy-sell agreements provide protection in case one partner is no longer able to maintain their role in the company due to an illness or injury.
Although the buy-sell agreement itself is not an insurance product, such an agreement is often funded by insurance. Business owners may not know about the need for disability buy-sell insurance and other disability insurance products for business owners, so this is a great opportunity for an insurance broker or financial adviser to prove their value (and make sales) by educating their business owner clients.
Why Business Partners Need a Buy Sell Agreement
Imagine you go into business with your friend. You like working with your friend – who is now also your business partner – and your business is thriving. Then your friend suffers a stroke. Your friend is permanently disabled and can’t help run the business anyone. Furthermore, your friend needs cash to help pay for medical costs. Do you buy your friend’s stake in the business? You might want to, but if you don’t have funds, you might not be able to. If you can’t buy your friend out, your friend could try to sell his share of the business to someone else – but then you’d be stuck with a new partner, and perhaps not one you would choose on your own.
Business partners should consider the possibility of disability carefully. If one partner needs out because of an illness or injury, will the other partner or partners buy them out? Or will they sell their stake in the business to someone else, or have family members take over? This isn’t something you want to have to figure out when a crisis happens. By ironing out a buy-sell agreement ahead of time, business partners can rest easy knowing what will happen, and they can avoid potentially ugly disputes.
Which of the Following Disability Buy-Sell Agreements Is Best Suited for Your Business Clients?
There are a few primary types of disability buy-sell agreements. Two common types are cross purchase agreements and entity purchase agreements. The wait-and-see agreement is another approach that acts as a kind of hybrid of the other two options. Business partners should consider these options carefully before deciding which type of buy-sell agree is right for their business.
Cross Purchase Agreement
A cross purchase agreement is a buy-sell agreement that applies when one partner dies or needs to sell their stake in the business, for example, due to disability. In this arrangement, the other partner or partners buy the departing partner’s stake in the business.
A cross purchase plan can be ideal for business partnerships that only involve two partners. When more partners are involved, a cross purchase agreement is still possible, but it may no longer be the best option.
Entity Purchase Agreement
In an entity purchase agreement, the company itself buys the shares from a business partner who dies or is otherwise unable to continue their role in the company. The term “stock redemption” is sometimes used for this type of arrangement.
An entity purchase agreement can be ideal for companies with more than two business partners.
Wait and See Agreement
When business partners create a buy-sell agreement, they are often planning for hypothetical situations that might occur decades in the future. Their situation may have changed drastically in the meantime. The relevant tax laws may have changed, as well. As a result, it can be difficult to know which type of buy-sell agreement is best.
The wait and see agreement may be a good option for business partners that want flexibility. Under this arrangement, when a partner needs a buyout, the other partners can decide then whether they want to buy the stake themselves as partners, have the company buy the stake, or have the partners and company split the purchase. Therefore, the wait and see agreement can end up being treated as a cross purchase agreement, an entity purchase agreement or a combination of the two. The partners have the flexibility to decide what makes the most sense at the time, while still benefiting from having a basic agreement regarding what happens to the departing owner’s interest in the business.
Buy-Sell Agreement Funding: Disability Insurance vs. Life Insurance Policy
One of the most important aspects of a buy-sell agreement is funding. It’s not enough to want to buy a partner’s stake in the business – you have to have the money to do so. However, if a business partner needs to exit the business suddenly and unexpectedly due to disability, or if the business partner dies unexpectedly, the funding may not be available.
Insurance can solve this problem.
There are two types of insurance policies that are commonly purchased in order to fund a buy-sell agreement. One is a life insurance policy, which can be used to fund a buy-sell agreement in the case of a business partner’s death. The other is a disability insurance policy, which can be used to fund a buy-sell agreement if a business partner experiences an illness or injury that makes a buyout necessary.
Because business partners don’t know what will trigger a buy-sell agreement – a disability or a death – it’s important to buy both life insurance and disability insurance. Additionally, because there are at least two business partners, there will need to be at least two life insurance policies and at least two disability insurance policies – one of each for each business partner. The policies can be owned by the individual partners or by the business itself, depending on the type of buy-sell agreement being used.
Key Elements to Include in Your Buy Sell Agreement
When you develop your buy-sell agreement, there are several things that need to be included. A lawyer should create the agreement to ensure that everything is covered, but here are some issues that the business co-owners will likely need to address:
- The Parties. The individual business owners will need to be named and take part in the agreement.
- The Triggers. Death and disability are two common triggers, but other events may also trigger the provisions in a buy-sell agreement. For example, when the business partners are also marriage partners, divorce may be another possible triggering event.
- Valuation: How much is the business partner’s stake worth? The business partner who is selling will want to get the fair market value, but the remaining owners won’t want to overpay. The buy-sell agreement should outline how the purchase price will be calculated.
- Funding: It’s smart to consider funding early on. In some cases, the business or purchasing owners may have sufficient funds to cover the buyout when one business owner leaves. A loan is another possibility in some cases, assuming approval can be secured. In many cases, it makes sense to fund the agreement with disability buyout and life insurance policies.
- Type: You will need to decide whether you want to set up a cross purchase, entity purchase or wait and see buy sell agreement.
Which Type of Buy Sell Arrangement Suits Your Company’s Needs?
A buy sell agreement is a legally binding document, and business partners should consider their options carefully before they enter into the agreement. When deciding whether to use a cross purchase, entity purchase or wait and see agreement, it’s important to consider multiple factors, such as:
- The number of partners. Agreements between two partners can be fairly simple, but agreements with several partners can get more complicated.
- The business structure. Is the business a limited liability partnership, an S corporation, a C corporation or something else? This can impact the details of the agreement.
- The funding. Will the company need to provide funding, or will the individual owners need to provide funding?
- The tax consequences. Whether the insurance policy benefits go to the remaining partners or the company, and whether the shares of the departing owner are purchased by the remaining partners or the company, can impact the taxes owed.
A lawyer can create the buy-sell agreement. It may also be helpful to have an accountant review the arrangement to consider the tax consequences and other financial implications.
Updating Your Buy-Sell Agreement
You may need to update or completely redo your buy-sell agreement after major changes. For example, if a new business partner joins the company, you will need a buy-sell agreement that reflects this.
It’s also important to update your insurance coverage at this time. For example, if you have a new business partner, you’ll also need a new disability buyout insurance policy and life insurance policy for that partner.
Other Disability Insurance Policies for Business Owners
Buy-sell disability insurance is an important coverage for any business owner with a business partner. However, it’s not the only disability insurance policy that a business owner may need.
Here are some additional coverage types that business owners should consider, whether or not they have business partners.
- Business Overhead Expense Insurance: Overhead expenses don’t stop just because a business owner experiences an illness or injury. Business overhead expense (BOE) policies cover certain operating expenses, such as rent, utilities, salaries, payroll taxes, property taxes and accounting fees if the insured experiences a qualifying disability. The maximum benefit period usually lasts for 12 to 24 months.
- Bank Loan Disability Insurance: Many business owners take out loans to fund their businesses, either when they first open or later when they want to expand. If the business owner experiences a qualifying disability, bank loan disability insurance covers the monthly loan obligation.
- Key Person Disability Insurance: Businesses can’t run without people. Some people are especially critical to the ongoing success of the company. If a key employee is unable to work because of an injury or illness, the business can suffer unexpected expenses. Key person disability insurance provides funds to the business if a covered worker experiences a qualifying disability. The maximum benefit period usually lasts for 12 to 24 months.
- Individual Disability Insurance: While other disability insurance policies like key person DI, bank loan DI and BOE help the business itself, individual disability insurance provides protection for the individual experiencing the disability. The benefits can help cover the disabled individual’s mortgage, bills, and other personal expenses.
- Multi-Life Disability Insurance: Instead of buying individual disability insurance, buying multiple insurance policies at once can make coverage more affordable. If there are three or more people who need coverage, multi-life DI can be a good option.
Do you need help securing disability insurance for your business owner clients? DIS can help.